Question

What are the advantages and disadvantages of formal, rule-based, impersonal exchange with third-party enforcement (often termed arm’s-length transaction) compared to informal institutions? Is one type of institution better than the other? Why or why not? How do formal and informal institutions complement each other?

Answer 1

One benefit of formal, rule-based, impersonal exchange with third-party enforcement (also known as arm's-length transaction) is that this type of transaction can be less likely to be affected by bias. For instance, when you exchange with a formal third-party when applying for a loan, there can be fewer biases and/or inappropriate judgements than there could be for an informal institution. More formal, impersonal, exchanges are more regulated and kept in check more than an informal institution may be. This can be helpful in a situation where someone is trying to do business or make an exchange, but for some reason may be judged or misconceived in an informal environment (whether it be for gender, race, education level, experience, sexual orientation, age, etc.) Formal and rule-based exchanges are based on rules and predetermined criteria and not on personal or informal judgements.

On the other hand, informal institutions may also have their place in regards to giving someone a chance who does not meet all of the rules or criteria to be considered by a formal institution. For instance, when going to a bank to apply for a loan it is usually quite strict and the criteria determining whether an individual can be prequalified or not is set in stone. Often, if the initial application gets denied no further conversation can even take place at that time because it has already been shut down. While, at an informal institution, the rules and regulations can be more relaxed which can in some ways have its own benefits to the party in question because even if the initial formal information does not look promising, further conversation and communication between the parties can take place, which may give that individual a better chance with a smaller and more informal institution who sees something in them that a formal institution may not take the time to look for.

It is inappropriate to assume that formal is inherently better than informal, because they are different and in some ways operate on different wavelengths, almost like comparing apples to oranges. To take formal and informal institutions and think of them in another way (politically): formal institutions are laws, policies, and regulations; while informal institutions are customs, social norms, and traditions (Defining institutions, 2014). Both are important and complement each other to create a diverse and complete society, but they are each very different components that operate differently within that society.

Explanation:

One way to go about answering questions like this can be by addressing it in different ways, like was touched upon above by referring to the question in terms of institutions themselves (like banks) and then also referring to the question more broadly as institutions such as laws (formal) and social norms (informal). This can be especially helpful in the event that the question or subject is unclear about what specific context the question is being taken in.

Reference:

Defining institutions. (2014, September).

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