The nexus of economic and institutional evolution

•As capital accumulates, informal institutions change via learning by doing.•Formal institutions are reformed optimally, subject to socio-economic costs.•Formal institutions exhibit a punctuated evolutionary pattern.•Heterogeneity in informal institutions delays formal reforms and growth.•Cultural heterogeneity lowers formal institutional quality.

The current state of the development economics literature ascribes an indisputable central role to institutions. This paper presents a formal model of institutional evolution that is based on the dynamic interactions between formal and informal institutions and economic development; the main features of the model is consistent with the fundamental theories that shed light to institutional evolution, namely the collective action and transaction cost theories, as well as dialectics. As informal institutional quality accumulates like technological know-how, while the level of formal institutional quality is chosen by the government to maximize welfare, subject to the economic and political costs. The solution of the model yields a punctuated trajectory of formal institutional evolution. Simulations reveal that the extent of diversity in informal institutional quality across a country delays formal institutional reforms. We also observe that, both the optimal quality of formal institutions and welfare are higher the more homogeneous is the country with respect to its informal institutions or the cultural attributes.