Can institutions explain why some parts of the world became rich and others did not? Did the political, legal, economic, and religious landscape of historical societies shape economic incentives in such a way that prosperity ensued in some places but not others?

Many of a society's political, legal, religious, and economic features are enmeshed in its institutions. In this chapter, we examine the literature on institutions. We begin by explaining what institutions are and why they impact economic development. We then show why different institutions in different parts of the world have placed societies on different economic trajectories.

For Douglass North, institutions are the rules of the game. North’s thinking about institutions evolved over the course of his career. Initially, North and Thomas (1973) supposed that institutions had a tendency to evolve towards efficiency. Over time, inefficient institutions would be weeded out and more efficient institutions would be promoted in the same manner as market competition weeds out less efficient firms in favor of their more efficient competitors.

Later, North (1981) came to the view that there is no process analogous to the competitive market process to "select" the most efficient institutions. The incentives in the political sphere differ from those in the marketplace. Hence, inefficient institutions can persist for decades or even centuries. Such inefficient institutions can be a source of lasting poverty. They may even be a leading cause of why some countries are rich and others are poor. Building on North’s insights, Greif (2006) developed an alternative definition of institutions. His framework incorporates the critical role cultural beliefs play in enforcing, and indeed constituting, institutions. Using these definitions, this chapter lays out how economists, political scientists, and historical sociologists have understood the role that institutions have played in shaping economic development in various societies.

For instance, one key component of institutions is the degree to which they permit economic freedom. The more economic freedom a society has, the more individuals are free to allocate their resources as they see fit. Economic freedom is closely associated with the rule of law. The figure at the top of this page shows the correlation between the rule of law and per capita GDP. While such correlations should not be taken as causal on face value, there is a large body of research suggesting that this is indeed a causal relationship.

Secure property rights are central to economic freedom. Secure property rights ensure that individuals earn a return on their investments. Property rights are also related to the rule of law. Where people have confidence that the government will enforce contracts and property rights, more economic transactions are likely to occur. However, the rule of law varies immensely across the world, as shown in the figure below. Is this one reason why some countries are wealthy and others are not?

Legal systems also vary tremendously across societies. Many small-scale societies rely on informal and decentralized legal systems based around ostracism and feuding. These legal systems differ considerably from those of large-scale agrarian states, let alone highly commercialized, market-oriented societies.

Many scholars have argued that the rule of law played a critical role in the rise of Western Europe. It provided a check on the power of government, guaranteed each individual their own private sphere of non-interference, and offered a platform of institutional stability conducive to long-run economic growth. The question is: where does the rule of law come from? This is an important question if we want to understand how some parts of the world became rich.

To give one example, an influential literature has emerged in the last few decades that attempts to understand the consequences of the legal origins of a society's legal system. La Porta, de Silanes, Shleifer, and Vishny (1998) argued that the English common law tradition is associated with better protection of property rights, less onerous regulations, and a more favorable environment for markets than systems based on Roman Law (such as the French or German legal systems). In particular, La Porta et al. argued that protection for investors was systematically stronger in common law countries.

While there has been some push back against this thesis, it is clear that the type of law that countries have is one of the important relics of the colonial era. Countries that were colonized by Europeans – which, as we will see in Chapter 6, was much of the world – tended to get their legal institutions (see the figure below).

There are many other types of institutions which affected historical economic growth. Perhaps most importantly, political institutions shape how we act. The state generally has something close to a monopoly on violence. It can therefore use force – or the threat of it – to incentivize people to act in certain ways.

Political institutions vary widely. This variation is one of the leading causes – and consequences – of differences in economic development. Social scientists have come up with numerous ways to measure these institutions, allowing us to compare them over space and time. One of the most widely used metrics, the polity score index (Marshall and Elzinga-Marshall, 2017), measures countries on a range from absolute autocracy to absolute democracy (see the figure below). These data track well with economic development.

After discussing the various reasons why institutions matter, this chapter proceeds to discuss specific historical periods in which institutional developments played a key role in a society's long-run economic trajectory. These include economic and financial institutions that emerged during Europe's "Commercial Revolution" (c. 1000-1300), medieval European guilds, the rise of parliaments and limited governance, the growth of European fiscal capacity (the ability to collect taxation) in the medieval and early modern periods, and the role that war played in developing states.

Equally important is understanding why institutional developments differed in other parts of the world, as well as within Europe. As we will see in later chapters, institutional developments cannot be understood in a silo. They are contingent on societal features such as culture, geography, and colonial legacy. Considered together, these features played a central role in how the world became rich.