Although the importance of institutions for economic growth is well-understood, no model with endogenously emerging institutions exists that would lend itself to policy analysis. We propose a new modelling framework, designed to fill this gap, where agents not only maximize their personal consumption, but also care about morality: they receive additional utility from cooperating with others by following social norms. Under these assumptions, we model the emergence of formal/informal and inclusive/extractive institutions for facilitating cooperation. Institutional change happens when moral agents choose between existing institutions on the basis of their profitability and “fairness” that is determined endogenously from the context of the game. We show with examples how the framework can accommodate well-known structural distortions that go along with poor quality of public institutions, such as informality and clientelism. We also demonstrate the usefulness of this approach for designing economic policy that can directly take institutions and their functioning into account. The framework allows for case-specific calibration that can help evaluate policy effectiveness, such as for example tax policy in the presence of a large informal sector.
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