Why do institutions matter? Why do they need to remain stable? These are important questions in the field of both economics and law, but it can become a very confusing, convoluted, and esoteric topic. What I hope to do with this post is, by using the metaphor of baseball, we can help make sense of institutions and their role.
What are institutions? Institutions are not much more than the “rules of the game.” They are the framework in which the “players” operate. Institutions matter because they affect the behavior and plans of the players. One such institutional question in baseball is “how will we crown a champion each season?” There are multiple ways of doing this: the top teams from each division play against each other in a tournament of multiple games (the current method), whoever scores the most runs over the course of the season, whoever has the greatest net runs (runs scored minus runs allowed), lottery method, etc. Each of these institutional methods have pluses and minuses, and each must be carefully considered as adopting a different one will result in different actions by teams and players.
Let’s say that Major League Baseball (MLB) decided to adopt the method “whoever scores the most runs over the course of the season” becomes the champion. Given this institution, teams would be incentivized to focus entirely on offense. Defense doesn’t really matter a whole lot under this institutional framework, and thus teams and players would spend lots of resources on offensive prowess and not much on building defense. You’d likely have long baseball games and huge, football-like scores.
Now, let’s say MLB institutes the “whoever has the highest net-runs” method. This would incentivize teams to increase focus on defense and not just on offense. A more balanced approach (but with still relatively strong focus on offense) would result.
Finally, let’s say MLB institutes a lottery method to determine the champion. Since the method is random and not dependent on performance, teams would also be incentivized to act randomly.
There are, of course, many other methods to choose from. With a little imagination, I’m sure the reader can come with other methods and think about how they would incentivize teams.
Once the method is chosen (however that is) it is important that it remain around. Unstable institutions (that is, the rules of the game changing frequently) make planning virtually impossible. Let’s say MLB institutes the “highest net run” method. Teams, when preparing for the season, sign and draft players they believe will help them achieve this goal. The season plays out and a champion is crowned. However, someone objects that the champion, while having the highest net run score, did not have the highest runs scored. It was unfair, they argued, that teams who scored more runs were denied the championship. So, MLB changes the rules (institutions). The teams, who had been planning for net runs must now scramble and re-do their teams, their contracts, and their plans to now score more runs. The next season comes and goes and a new champion is crowned. However, someone objects that the champion, while having the highest runs scored, did not win the most games. It’s unfair that the team who didn’t win the most games is not the champion. So, MLB changes the institution again. And again, teams who had built and planned for scoring the most runs must now scramble and adjust their plans. If this process repeats season after season, teams won’t know how to plan. They can’t draft efficiently, they can’t plan contracts or payrolls with any accuracy. In short, it becomes about moving from one fire to the next, just trying to keep up with the fluctuating changes. I suspect some players will jump ship and go to other, more stable, leagues.
In short, institutions incentivize behavior of the participants and stable institutions are necessary for participants to plan more than just a few days in advance. Long term goals, long term growth, is dependent on stable institutions.