Institutional Change

Theory and Empirical Findings

Sven-Erik Sjostrand

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781315486239
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This book brings together some 15 papers drawn from the 330 papers presented at the Third Annual Conference of the Society for the Advancement of Socio-Economics in Stockholm, Sweden in June 1991. Part 1 outlines a basic theory of institutional change; Parts 2 and 3 examine case studies in international experience with institutional change. The authors of the original papers include Douglas North, Amitai Etzioni, Oliver Williamson, as well as eminent scholars from Eastern and Western Europe, representing views and analyses from ten different countries.

Part I.
Institutional Change: Basic Theory

2. Institutional Change: A Framework of Analysis

Douglass C. North

A theory of institutional change is essential for further progress in the social sciences in general and economics in particular. Essential because neoclassical theory (and other theories in the social scientist's tool bag) at present cannot satisfactorily account for the very diverse performance of societies and economies both at a moment of time and over time. The explanations derived from neoclassical theory are not satisfactory because, while the models may account for most of the differences in performance between economies on the basis of differential investment in education, savings rates, and so forth, they do not account for why economies would fail to undertake the appropriate activities if they had a high payoff.¹ Institutions determine the payoffs. While the fundamental neoclassical assumption of scarcity and hence competition has been robust (and is basic to this analysis), the assumption of a frictionless exchange process has led economic theory astray. Institutions are the structure that humans impose on human interaction and therefore define the incentives that, together with the other constraints (budget, technology, etc.), determine the choices that individuals make that shape the performance of societies and economies over time.

In the following pages, I sketch out a framework for analyzing institutions. This framework builds on the economic theory of choice subject to constraints. However, it incorporates new assumptions about both the constraints that individuals face and the process by which they make choices within those constraints. Among the traditional neoclassical assumptions that are relaxed are those of costless exchange, perfect information, and unlimited cognitive capabilities. Too many gaps still remain in our understanding of this new approach to call it a theory. What I do provide are a set of definitions and principles and a structure that provides much of the scaffolding necessary to develop a theory of institutional change.

Institutions and Organizations: Definitions and Descriptions

Institutions consist of formal rules, informal constraints (norms of behavior, conventions, and self-imposed codes of conduct), and the enforcement characteristics of both. The degree to which there is an identity between the objectives of the institutional constraints and the choices individuals make in that institutional setting depends on the effectiveness of enforcement. Enforcement is carried out by the first party (self-imposed codes of conduct), by the second party (retaliation), and/or by a third party (societal sanctions or coercive enforcement by the state). Institutions affect economic performance by determining (together with the technology employed) transaction and transformation (production) costs.

If institutions are the rules of the game, organizations are the players. They are groups of individuals engaged in purposive activity. The constraints imposed by the institutional framework (together with the other constraints) define the opportunity set and therefore the kind of organizations that will come into existence. Given its objective function—for example, profit maximization, winning elections, regulating businesses, educating students—the organization, which may be a firm, a political party, a regulatory agency, a school or college, will engage in acquiring skills and knowledge that will enhance its survival possibilities in the context of ubiquitous scarcity and hence competition. The kinds of skills and knowledge that will pay off will be a function of the incentive structure inherent in the institutional matrix. If the highest rates of return in a society are to be made from piracy, the organizations will invest in knowledge and skills that will make them better pirates; if organizations realize the highest payoffs by increasing productivity, then they will invest in skills and knowledge to achieve that objective. Organizations may not only directly invest in acquiring skills and knowledge but indirectly (via the political process) induce public investment in those kinds of knowledge that they believe will enhance their survival prospects.

The new (or neo-) institutional economics has produced a substantial literature dealing with institutions and organizations. The property rights literature (Alchian 1965/1977; Demsetz 1967), for example, analyzes the implications of institutions and organizations for performance, but in most of it the formation and evolution of institutions and organizations remain exogenous to the analysis. Williamson (1975,1985), treating die institutional framework as exogenous, explores the transaction and transformation costs of various organizational forms. My objective (North 1990 as well as here) is to put forth an explanation of institutional (and organizational) change that is endogenous, an essential step in my view to further progress in economic history and economic development.

Institutional Change: Agents, Sources, Process, and Direction

The agent of change is the entrepreneur, the decision maker(s) in organizations. The subjective perceptions (mental models) of entrepreneurs determine the choices they make. The sources of change are the opportunities perceived by entrepreneurs. They stem from either external changes in the environment or the acquisition of learning and skills and their incorporation in the mental constructs of the actors. Changes in relative prices have been the most commonly observed external sources of institutional change in history, but changes in taste have also been important. The acquisition of learning and skills will lead to the construction of new mental models by entrepreneurs to decipher the environment; in turn, the models will alter perceived relative prices of potential choices. In fact, it is usually some mixture of external change and internal learning that triggers the choices that lead to institutional change.

Deliberate institutional change will come about, therefore, as a result of the demands of entrepreneurs in the context of the perceived costs of altering the institutional framework at various margins. The entrepreneur will assess the gains to be derived from recontracting within the existing institutional framework compared to the gains from devoting resources to altering that framework. Bargaining strength and the incidence of transaction costs are not the same in the polity as in the economy; otherwise it would not be worthwhile for groups to shift the issues to the political arena. Thus entrepreneurs who perceive themselves and their organizations as relative (or absolute) losers in economic exchange as a consequence of the existing structure of relative prices can turn to the political process to right their perceived wrongs by altering that relative price structure. In any case, it is the perceptions of the entrepreneur—correct or incorrect—that are the sources of action.

Changes in the formal rules may come about as a result of legislative changes such as the passage of a new statute, of judicial changes stemming from court decisions that alter the common law, of regulatory rule changes enacted by regulatory agencies, and of constitutional rule changes that alter the rules by which other rules are made.

Changes in informal constraints—norms, conventions, or personal standards of honesty, for example—have the same originating sources of change as do changes in formal rules; but they occur gradually and sometimes quite subconsciously as individuals evolve alternative patterns of behavior consistent with their newly perceived evaluation of costs and benefits.

The process of change is overwhelmingly incremental (although I shall deal with revolutionary change later in this chapter). The reason is that the economies of scope, the complementarities, and the network externalities that arise from a given institutional matrix of formal rules, informal constraints, and enforcement characteristics will typically bias costs and benefits in favor of choices consistent with the existing framework. The larger the number of rule changes, ceteris paribus, the greater the number of losers and hence opposition. Therefore, except in the case of gridlock (described in the next paragraph), institutional change will occur at those margins considered most pliable in the context of the bargaining power of interested parties. The incremental change may come from a change in the rules via statute or legal change. For informal constraints there may be a very gradual withering away of an accepted norm or social convention or the gradual adoption of a new one as the nature of the political, social, or economic exchange gradually changes.

The direction of change is determined by path dependence. The political and economic organizations that have come into existence in consequence of the institutional matrix typically have a stake in perpetuating the existing framework. The complementarities, economies of scope, and network externalities just mentioned bias change in favor of the interests of the existing organizations. Both the interests of the existing organizations that produce path dependence and the mental models of the actors—the entrepreneurs—that produce ideologies "rationalize" the existing institutional matrix and therefore bias the perception of the actors in favor of policies conceived to be in the interests of existing organizations.

Both external sources of change and unanticipated consequences of their policies may weaken the power of existing organizations, strengthen or give rise to organizations with different interests, and change the path. The critical actor(s) in such situations will be political entrepreneurs whose degrees of freedom will increase in such situations and, on the basis of their perception of the issues, give them the ability to induce the growth of organizations with different interests (or strengthen existing ones).

Revolutionary change occurs as a result of a gridlock arising from a lack of mediating institutions that enable conflicting parties to reach compromises that capture some of the gains from potential trades. The key to the existence of such mediating political (and economic) institutions is not only formal rules and organizations but also informal constraints that can foster dialogue between conflicting parties. The inability to achieve compromise solutions may also reflect limited degrees of freedom of the entrepreneurs to bargain and still maintain the loyalty of their constituent groups. Thus, the real choice set of the conflicting parties may have no intersection, so that even though there are potentially large gains from resolving disagreements, the combination of the limited bargaining freedom of the entrepreneurs and a lack of facilitating institutions makes it impossible to do so.

Revolutionary change, however, is never as revolutionary as its rhetoric would have us believe. It is not just that the power of ideological rhetoric fades as the mental models of the constituents confront their Utopian ideals with the harsh realities of post-revolutionary existence. Formal rules may change overnight, but informal constraints do not Inconsistency between the formal rules and the informal constraints (which may be the result of deep-seated cultural inheritance because they have traditionally resolved basic exchange problems) results in tensions that typically get resolved by some restructuring of the overall constraints—in both directions—to produce a new equilibrium that is far less revolutionary than the rhetoric.

The Framework Illustrated

An extended sketch from American economic history illustrates the way in which institutions, organizations, and the mental models of the actors interact to produce institutional change.

The basic institutional framework of the American colonies that had been carried over from England provided a hospitable environment for economic growth. The incentive structure not only encouraged decentralized and local political autonomy but also provided low-cost economic transacting through fee simple ownership of land (with some early exceptions in proprietary colonies) and secure property rights. The organizations that arose to take advantage of the resultant opportunities—colonial assemblies, plantations, merchant houses, shipping firms, family farms—produced a thriving colonial economy. But the entire colonial period was one of a long learning process—discovering staple exports (tobacco, fish, rice, indigo); developing markets (West Indies, Southern Europe); improving productivity (substituting slaves for indentured servants on tobacco plantations, reducing turnaround time in shipping). In brief, the learning resulted in reducing transaction or transformation costs or in increasing revenues that resulted in improving the efficiency of the colonial economy.

While planters, merchants, shippers, and farmers could and did make modest changes in the institutional framework as their perceived needs changed, they were basically limited by their colonial status—not perceived as a serious burden as long as the threat of French and Indian intervention was present. With the elimination of that threat with the French and Indian War (1755-63), the colonists increasingly perceived their interests as divergent from Britain and its colonial policies. The American Revolution was sparked not only by changes in the institutions such as the Quebec Act (cl...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• Preface
• Acknowledgement
• Introduction
• Part I: Institutional Change: Basic Theory
• Part II: Comparative Analyses of Institutional Structures and Changes
• Part III: Changing Institutions: Focusing on Experiences in Northern and Eastern Europe
• Retrospection
• Index
• About the Authors and the Editor