Definition
Institutions are the durable rules — formal law, customary practice, and the organizations that enforce both — that govern who may transact with whom, on what terms, and with what protection. Adam Smith does not use the word in the modern technical sense, but his analysis is institutional throughout: property rights, courts, navigation acts, apprenticeship rules, settlement laws, chartered companies, and the policies of princes all enter the argument as forces shaping what markets can do.
Modern economics treats institutions as the slow-moving substrate beneath prices and quantities. The same goods, the same technologies, and the same workforce produce dramatically different outcomes under different institutional rules.
Why it matters
How it works
Smith's argument is that the division of labor and the market that supports it produce wealth only when institutions allow them to operate. Settlement laws that forbid a labourer from moving to where the work is reduce the effective size of the market. Apprenticeship statutes that prevent newcomers from entering a trade protect existing producers and impoverish consumers. Mercantilist trade policy directs capital away from its most productive uses. In every case the institutional rule is the binding constraint, not the underlying economics.
The corollary is that institutional reform is often the highest-leverage intervention available. Smith's policy program — clear property rights, equal taxation, abolition of internal trade barriers, repeal of statutes that bind labour to a parish — is institutional, not technological. The same energies that exist under bad rules will produce more output when the rules are changed.
The contemporary version is the literature on inclusive versus extractive institutions, on the rule of law as a prerequisite for investment, and on regulatory reform as a development strategy. Smith would recognize the questions immediately.