Institutions, innovation and development economics

Detail

1. Institutional economics: the basic idea

• Institutional economics studies how laws, property rights, social norms and organisations shape how people behave in the economy and what results they get.
• Institution means a rule or practice that people follow again and again. Some are formal, such as a law or a contract. Some are informal, such as a custom or a caste norm.

• Property rights are legal rights to own, use, sell and earn income from an asset.

• Core claim: markets do not work on their own. They sit inside rules. Two countries can have the same resources and still grow very differently because their rules are different.

2. Old institutionalists

• Thorstein Veblen wrote The Theory of the Leisure Class (1899).
• He coined the term conspicuous consumption, which means buying costly goods to show off status, not for their use.
• Veblen goods grow out of this idea. For these goods, demand can rise when the price rises, because a high price itself signals status. Examples are luxury watches and designer bags. This is an exception to the law of demand.

• Exam trap: a Giffen good is also an exception, but it is an inferior good bought by poor people, such as a staple grain. Do not mix it up with a Veblen good.

• John R. Commons studied how law, courts and collective action shape the economy. His work covered labour laws and trade unions.

• The old institutionalists wrote mostly in words and history. They used little mathematics.

3. New institutional economics (NIE)

• New institutional economics studies institutions through three tools: transaction costs, property rights and contracts. Unlike the old school, it keeps the standard economist's tools of choice and cost.
• Ronald Coase, "The Nature of the Firm" (1937), Nobel 1991.
• Transaction costs are the costs of using the market: finding a seller, bargaining, writing a contract and enforcing it.
• Why firms exist: inside a firm, a manager can simply give orders. This saves the cost of signing a fresh market contract for every task.

• Worked example:

  • A publisher hires a freelance editor for each book. Every contract costs ₹5,000 in search and negotiation. For 100 books this adds up to ₹5 lakh.
  • A salaried editor also costs extra, for example ₹3 lakh a year in supervision beyond the salary.
  • Since ₹3 lakh < ₹5 lakh, the publisher does the work inside the firm ("make" rather than "buy"). A firm grows until the cost of organising one more task inside it equals the cost of buying it on the market.

• Douglass North (Nobel 1993): institutions are "the rules of the game" of a society. Organisations such as firms, parties and unions are the players.

• Oliver Williamson studied how firms are governed. He asked when it is better to use markets and when to use hierarchies.
• Elinor Ostrom studied how communities manage the commons. Commons are shared resources such as forests, fisheries and groundwater.
• She showed that local users can make their own rules and avoid the "tragedy of the commons" (overuse of a shared resource because no one owns it). So neither state control nor privatisation is always needed.

• She was the first woman to win the economics Nobel.

• Williamson and Ostrom shared the 2009 Nobel.

• Indian link: joint forest management and water-user associations work on Ostrom-type ideas.

4. Acemoglu–Johnson–Robinson (AJR): inclusive vs extractive institutions

• Daron Acemoglu, Simon Johnson and James A. Robinson won the 2024 Nobel "for studies of how institutions are formed and affect prosperity" [2].
• Inclusive institutions protect property rights, keep the rule of law and let many people take part in the economy and in politics. These bring prosperity.
• Extractive institutions take income and wealth from the many and give it to a small elite. They make a few people rich.
• Their finding: societies with inclusive political and economic institutions are more prosperous than those with exploitative systems that limit people's participation [2].
• Colonial origins argument:
• Where settlers stayed, as in the USA and Australia, colonisers built inclusive institutions for themselves.
• Where colonisers only took resources out, they built extractive institutions.

• These institutions outlived colonial rule. They explain much of today's gap between rich and poor nations.

• Why bad institutions last:

• Good economics is not always good politics.
• Some leaders fear that growth-friendly reforms will weaken their hold on power, so inefficient institutions survive [3].

5. Path dependence

• Path dependence means past choices limit the choices we have today. A historical accident can lock in an outcome even when a better option exists later.
• Classic example: the QWERTY keyboard.
• It was designed for early typewriters.
• Once typists had trained on it and firms had bought it, switching became too costly.

• So QWERTY stayed, even though other layouts may be as good or better.

• Indian example (Banerjee–Iyer):

• Under the British, some districts came under zamindari (landlord-based) land revenue. Here landlords collected rent and paid revenue to the state.
• Other districts came under raiyatwari, where the cultivator paid revenue directly to the state.
• Even after independence, former zamindari districts show lower agricultural investment and productivity, such as less irrigation and fertiliser use.
• The colonial land institution still shapes outcomes today.

6. Innovation: Schumpeter and creative destruction

• Joseph Schumpeter wrote Capitalism, Socialism and Democracy (1942).
• Creative destruction: new products, technologies and firms keep replacing old ones, and this constant replacement drives growth. Examples: digital cameras replaced film cameras, and smartphones replaced basic phones.
• The hero of growth is the innovating entrepreneur, who brings in new combinations: a new product, method, market, input source or organisation.
• How creative destruction works:
• An entrepreneur innovates and earns a temporary monopoly profit (extra profit because they are the only seller for a while).
• Rivals copy or improve on the idea, so the old firm's profit disappears.

• Resources move to more productive uses, and output per person rises.

• Modern formal work:

• Aghion–Howitt (1992) built a formal growth model, published in Econometrica as "A Model of Growth Through Creative Destruction" [5].

• Joel Mokyr traced the cultural and scientific roots of sustained growth. He showed how scientific inquiry and openness to new ideas made continuous innovation possible during the Industrial Revolution [4].

• 2025 Nobel (announced 13 October 2025), "for having explained innovation-driven economic growth" [4]:

• one half went to Mokyr, for identifying the prerequisites for sustained growth through technological progress;

• the other half went jointly to Aghion and Howitt, for the theory of sustained growth through creative destruction [4].

• Growth-model detail is in growth-theories-business-cycles.

7. Development economics: pioneers

• Development economics studies how low-income economies achieve growth, structural change and poverty reduction. Structural change means workers and output shifting from agriculture to industry and services.

Economist	Key idea	Year / Nobel
Arthur Lewis	Dual-sector model: a traditional farm sector with surplus labour (workers whose removal does not reduce farm output, i.e. disguised unemployment) supplies cheap labour to a modern industrial sector. Industry grows by absorbing these workers.	1954; Nobel 1979, shared with T.W. Schultz
Paul Rosenstein-Rodan	Big push: many industries must be started together with large investment. One factory alone fails because it has no buyers, but many factories create demand for each other.	1943
Ragnar Nurkse	Vicious circle of poverty: low income → low saving → low investment → low productivity → low income. Answer: balanced growth, meaning investment across many sectors at once.	1953
Albert Hirschman	Unbalanced growth: invest first in key sectors with strong linkages. Backward linkages create demand for inputs (e.g. car factory → steel). Forward linkages supply inputs to other sectors (e.g. steel → machines).	1958
Gunnar Myrdal	Asian Drama (1968). He called South Asian states a "soft state": a state that makes laws and policies but does not enforce them firmly.	Nobel 1974
Amartya Sen	Capability approach: development means expanding what people are actually able to do and be, not only income. Entitlement theory of famines (Poverty and Famines, 1981): famines come from a collapse of people's command over food (wages, prices, rights), not just from a food shortage. Example: Bengal Famine, 1943.	Nobel 1998
Banerjee–Duflo–Kremer	RCT-based poverty research. An RCT (randomised controlled trial) gives a policy to a randomly chosen group and compares it with a group that did not get it.	Nobel 2019

• Sen's capability approach underlies the UNDP Human Development Index.
• Lewis vs Schultz: Lewis stressed surplus farm labour. Schultz argued that traditional farmers are "poor but efficient" and need new technology and human capital.

8. Structuralism (Latin America)

• Structuralism argues that the structure of poor economies, such as dependence on primary exports, keeps them behind. Free markets alone will not fix this.
• Prebisch–Singer hypothesis (Raúl Prebisch and Hans Singer, 1950): the terms of trade of primary-commodity exporters fall over time.
• Terms of trade (ToT) = (Index of export prices ÷ Index of import prices) × 100.
• Worked example:
  • A coffee exporter's export price index rises from 100 to 110 over a decade. Its import price index for machinery rises from 100 to 140.
  • ToT = (110 ÷ 140) × 100 ≈ 78.6, down from 100.
  • The country must now export about 27% more coffee to buy the same machines.

• Why ToT falls:

  • As people get richer, demand for primary goods grows slowly (low income elasticity of demand).
  • Manufactured goods gain value through technology and firms' market power.

• Their answer: state-led industrialisation through import substitution industrialisation (ISI). This means making at home the goods you used to import, protected by tariffs and quotas.

• This is the same logic as India's inward-looking trade policy of 1950–1990 (cross-ref planning and industrial policy topics).

9. Dependency theory

• Dependency theory: poor "periphery" countries stay poor because of their exploitative links with the rich "core". The core takes raw materials and surplus from the periphery.
• Andre Gunder Frank called this the "development of underdevelopment" (1966). On this view, underdevelopment is not an original state; the global system produces it.
• Indian precursor: Dadabhai Naoroji's drain theory. A part of India's wealth was transferred to Britain without any matching return, through Home Charges, salaries, pensions and profits.
• Class 11, Indian Economy on the Eve of Independence: the colonial aim was to make India "a raw material supplier for Great Britain's own rapidly expanding modern industrial base".

10. The developmental state

• Developmental state: a state that directs industrialisation through planning, industrial policy and close work with business.
• Chalmers Johnson, MITI and the Japanese Miracle (1982), is the key study. MITI was Japan's Ministry of International Trade and Industry.

• South Korea and Taiwan are other cases.

• Embedded autonomy (Peter Evans):

• The state stays close to business, so it gets information and can coordinate.
• It is not captured by business, meaning it does not simply serve their private interests.

• Support is given in return for performance, for example export targets.

• Contrast: India's licence raj. A licence raj is a system where firms need government licences to start, expand or change production.

• Class 11, Indian Economy 1950–1990: industrialists spent more time "trying to obtain a license or lobby" than improving their products.
• India gave protection without demanding performance. In Evans's terms, this is weak embedded autonomy.

11. Industrial policy returns

• Production Linked Incentive (PLI) schemes (2020). A PLI scheme pays firms an incentive linked to their extra output (incremental sales) made in India.
• Outlay: ₹1.91 lakh crore, across 14 sectors [6].
• Sectors include mobiles and electronic components, APIs and drug intermediates, medical devices, automobiles and auto components, pharmaceuticals, specialty steel, telecom, IT hardware, white goods, food products, textiles (MMF and technical), solar PV modules, ACC batteries, and drones [6].

• Results as of 31 Dec 2025 [6]:

  • 836 applications approved;
  • investment above ₹2.16 lakh crore;
  • sales above ₹20.41 lakh crore;
  • exports above ₹8.3 lakh crore;
  • more than 14.39 lakh direct and indirect jobs;
  • ₹28,748 crore paid out as incentives.

• India Semiconductor Mission (ISM).

• The Union Cabinet approved it in December 2021, with an outlay of ₹76,000 crore, for chip fabrication, display manufacturing and chip design [7].
• It gives fiscal support of up to 50% of project cost for eligible units [7].
• By Dec 2025, 10 projects worth ₹1.60 lakh crore of investment had been approved across 6 states [8].

• ISM 2.0 was announced in the Union Budget 2026–27 [9].

• USA: the CHIPS and Science Act (2022) gives subsidies for domestic chip-making.

• This link comes from the Evans framework above, not from the sources. PLI pays only after output is achieved, which is a performance condition of the East Asian kind. It is unlike licence-raj protection, which asked for nothing in return.

Prelims Hooks

• "Rules of the game" is Douglass North (Nobel 1993), not Coase. Coase (1937, Nobel 1991) explained firms through transaction costs.
• 2009 Nobel: Williamson (governance) and Elinor Ostrom (commons). Ostrom was the first woman to win the economics Nobel.
• Conspicuous consumption comes from Veblen, The Theory of the Leisure Class (1899). A Veblen good is an exception to the law of demand, but it is not a Giffen good.
• 2024 Nobel: Acemoglu, Johnson and Robinson, for how institutions are formed and affect prosperity (inclusive vs extractive) [2].
• 2025 Nobel: half to Mokyr; the other half jointly to Aghion and Howitt (1992 creative-destruction model) [4][5]. "Creative destruction" as a term belongs to Schumpeter (1942).
• Pairs to remember:
• Balanced growth = Nurkse.
• Unbalanced growth and linkages = Hirschman.
• Big push = Rosenstein-Rodan.
• Soft state = Myrdal.

• Surplus labour = Lewis.

• Sen's entitlement theory: a famine can happen even when food is available. The cause is the loss of people's command over food.

• Prebisch–Singer: primary exporters' terms of trade decline. ToT = (Px index ÷ Pm index) × 100.
• "Development of underdevelopment" is A.G. Frank (1966). Drain theory is Dadabhai Naoroji.
• PLI covers 14 sectors with a ₹1.91 lakh crore outlay [6]. ISM has a ₹76,000 crore outlay (approved Dec 2021) [7].

Mains Points

• Institutions and India's growth: AJR and Banerjee–Iyer show that colonial extractive institutions, such as zamindari and the drain, left effects that still last. Reform priorities follow from this:
• secure land titles;
• faster contract enforcement;

• judicial capacity.

• Why reforms get stuck: elites resist reforms that would weaken their power [3]. This is a political-economy argument for GS-II/III answers on stalled reforms such as land and labour.

• Industrial policy, then and now: the licence raj gave protection without asking for performance, and firms became rent-seekers. The East Asian developmental state used embedded autonomy and export discipline. PLI's output-linked payouts [6] and ISM's co-funding [7] move India towards the East Asian model. The risks:
• high fiscal cost;
• capture by a few large firms;

• low domestic value addition in assembly-led sectors.

• Growth through creative destruction: Schumpeter and the 2025 Nobel [4] suggest India needs these policies to keep firms entering and leaving:

• easy entry and exit (IBC);
• competition policy (CCI);
• R&D spending;
• openness to ideas.

Protecting old, inefficient firms slows long-run growth. Sen's capability approach adds that growth must turn into health, education and freedom.