Institutions to Support Markets

• Author: Roumeen Islam
• Position: Director of the World Bank's World Development Report 2002: Building Institutions for Markets (New York: Oxford University Press for the World Bank)

To spur growth and reduce poverty, poor countries will need efficient formal and informal institutions that support market activity. A major World Bank study offers insights into how such institutions may be developed.

In the eleventh century, the Maghribi merchants of North Africa wanted to expand their business throughout the Mediterranean region. Although cross-border trade was generally free and unrestricted, it was fraught with uncertainty and risk. Selling prices in foreign markets were unknown, and merchants could ensure the safe arrival and sale of their goods only by accompanying shipments to foreign trading centers. The Maghribis established agents in all of the major trading centers around the Mediterranean to represent their interests and gather information on foreign markets. Because the agents were from the Maghribi community, they were trusted. The merchants no longer had to travel to ensure that they were not being cheated, and information flowed freely. The informal institution they developed to deal with problems commonly faced by market participants allowed mutually beneficial business relationships and cross-border trade to flourish.

This is one of the many examples cited in the World Bank's World Development Report 2002: Building Institutions for Markets, which addresses the question of what kinds of institutions developing countries need to support their fledgling market economies. The report takes as a given that institutions matter, moving the debate forward by exploring how governments can build better institutions to support market development. It concludes that we need to build on existing institutions, seek simpler solutions in poor countries, and look at both the supply and the demand sides. The challenge now for these countries and the international community is to put these insights to work.

Identify institutional problems

The first step is recognizing when institutional inadequacies are to blame for problems in developing countries. This means asking which institution is missing or not working properly. Here, we define institutions as rules (informal customs as well as laws) that govern behavior, the mechanisms (often organizations or reputations) that enforce these rules, and the organizations (for example, clubs and banks) that affect peoples' incentives and support market transactions.

We have learned that attention needs to be focused, first, on the functions that institutions need to perform, and, second, on a particular institutional design or structure. Institutions that support market transactions perform three functions: smoothing information asymmetries (that is, ensuring that all market participants have access to reliable information), defining and enforcing property rights and contracts, and regulating competition.

By focusing on needed functions, governments can figure out whether the problems they face are caused by institutional failures and, if so, what kind. An Eastern European country found that its small and medium-sized firms were unable to obtain financing, even though it had created special banks to provide financing to these types of firms. The special banks proved to be risk averse and did not want to lend to smaller...