Category: Emergence of Institutions

How institutions change

The institutional framework emerges from the interactions of people in a society. These interactions are shaped by the dominant beliefs in a society. Beliefs shape how people perceive reality and how they respond to it. Dominant beliefs are those held by people who have the power to shape policy in a society. According to North (2005:2), belief systems provide “both a positive model of the way the system works and a normative model of how it should work”.

Institutional change occurs when people who are able to influence policy decisions perceive the current institutional framework as not performing effectively with regard to whatever measure of success they deem appropriate – generally in generating economic benefit for them and their social group. Institutional change is an intentional process shaped by actors who can achieve a certain amount of dominance through a combination of legitimacy, influence or power – it often happens by new actors getting in a position of legitimacy, influence and power.

Institutions continuously evolve based on how actors who can gain influence make sense of their perceived reality, how they evaluate institutional performance and the subsequent intention of these actors to adapt the institutions to optimise economic outcomes. There is a feedback loop between dominant belief systems and the institutional landscape. Beliefs determine the structure and evolutionary direction of the institutional landscape. The institutional landscape in turn shapes the behaviour of the economic actors and ultimately determines economic performance. The perceptions of the actors on the effectiveness of the current institutional framework shape their beliefs, and in turn again determine the drive of the actors in the system to change and adapt the institutional landscape.

One consequence of institutions being rooted in beliefs in a society is that institutional change is an inherently local process – it is much harder to impose institutions from the outside. At the same time, a local learning process might take a very long time. Rodrik (2000) and Hollingsworth (2000) claim that the embeddedness of markets in a distinct social system is the reason why configurations of institutional arrangements that govern the behaviour of actors in one society cannot easily be transferred to another. Societies can borrow selected principles, but the effectiveness of such borrowing is often limited due to differences in culture, management styles and work practices.

Transplanting institutions is something development programmes often attempt. While these externally designed institutions are sometimes dutifully adopted by recipient countries, they remain essentially dysfunctional on the inside. Andrews, Pritchett and Woolcock (2012) call this phenomenon ‘isomorphic mimicry’. Hence, as North (2005:viii) stresses, rather than design ‘better’ institutions, “the focus of our attention, therefore, must be on human learning – on what is learned and how it is shared among the members of a society and on the incremental process by which the beliefs and preferences change, and on the way in which they shape the performance of economies through time.”

Understanding human perception and how people learn provides insights into how people update their beliefs. As the beliefs of people or groups in power have a dominant effect on the institutional landscape, development cannot be apolitical but needs to be mindful of given power structure if it wants to achieve de facto and not only pro forma institutional change. Institutional quality also seems to depend on the way power is distributed. Rodrik (2000) contends that participatory political regimes deliver high-quality growth, mainly because they produce superior institutions better suited to local conditions.

A second consequence is that institutional change is strongly path dependent – the current institutional framework and its history define how institutions can change in the future. As North puts it: “We inherit the artifactual structure – the institutions, beliefs, tools, techniques, external symbol storage systems – from the past. Broadly speaking this is our cultural heritage” (North, 2005:156). Path dependence is another reason why institutional change needs to occur locally and the form of change cannot be imposed externally. The change that development agents deem necessary might not be possible given the history of how current institutions evolved. Path dependence makes institutional change an incremental rather than a radical process, so institutional change takes time.

When targeting institutional change it is important to bear in mind what North (2005:156) stated: “The degree to which such cultural heritage is ‘malleable’ via deliberate modification is still very imperfectly understood”. North points out three specific challenges (North, 2005:157):

  • The institutional structure inherited from the past may reflect a set of beliefs that are impervious to change either because the proposed changes run counter to that belief system or because the proposed alteration in institutions threatens the leaders and entrepreneurs of existing organisations.
  • The artefactual structure that defines the performance of an economy comprises interdependent institutions; changing just one institution in an attempt to get the desired performance is always an incomplete and sometimes a counter-productive activity.
  • A mixture of formal and informal institutions and their enforcement characteristics defines institutional performance; and while the formal institutions may be altered through policy decisions, the informal institutions are not amenable to deliberate short-run change, and the enforcement characteristics are only very imperfectly subject to deliberate control.

Institutions, formal or informal, do not emerge or change in isolation. They evolve over time in tandem with a society’s perceptions, attitudes and beliefs. They are also interrelated and influence each other. Formal organisations that embody institutional functions often learn from other organisations, so an innovation in an unrelated institution could spill over into other institutions. Institutions also do not emerge in single sectors or even in single regions in isolation. Although they might show regional or sectoral specificities, institutions are a society-wide phenomenon. As North noted (second bullet above), optimising institutions in isolation is likely to miss having a systemic, long-term impact. This makes it even more important that institutional change is seen through an evolutionary lens, where change is not about fixing current problems but about nurturing a process of evolutionary change through encouraging exploration and the creation of options.

While this shows that achieving institutional change is far from quick and easy – indeed, institutional economists like North argue that changing central institutions can take generations – there is an emerging field of ‘path creation’ for institutional change (Sydow, Windeler, Müller-Seitz & Lange, 2012; Garud, Kumaraswamy & Karnøe, 2010). Importantly, in this model agency for change is internal to the system, rather than external, distributed and emergent through the interactions of actors and artefacts.

Changing economic performance requires diverse institutional changes that go beyond interventions on micro-level interactions between companies and individuals and macro-level framework conditions. Esser, Hillebrand, Messner and Meyer-Stamer (1996) define two additional levels of institutional interactions. Firstly, societies need to be open to change in general and open to change that favours economic evolution in particular. If, for example, a society does not tolerate failure, companies will not take the risk of experimenting with new ideas as this might threaten their very existence. Esser et al. (1996) term a society’s disposition to create a favourable environment for economic development the ‘meta-level’. Further, there is a need for specialised supporting institutions that tackle persistent patterns of underperformance in economies that cannot be solved by individual actors[1]. One such institution is, for instance, a broad agreement that a performance issue or pervasive pattern of behaviour should be addressed. This institution then results in organisations, programmes, projects or infrastructure being created to address this issue. An example of persistent underperformance that slows economic evolution is an underinvestment by the private sector in, for instance, skills development. An institution could emerge whereby it is agreed that skills development is lagging and should be addressed. This could be addressed, for instance, by investing in public education and integrating vocational training with on-the-job training. Non-governmental organisations may become involved in helping to re-train workers who have lost their jobs due to outdated skill sets. Even some private initiatives to upgrade worker’s families may be established, and the government might create an incentive for companies to absorb young learners as interns. Esser et al. (1996) call this layer the ‘meso-level’, which consists of initiatives that emerge to address patterns of underperformance at the micro level. They assert that dynamic development is not the result of isolated interventions, but of the way numerous factors, priorities and policies interact on the micro, meso, macro and meta levels to shape economic performance. Central to this process are organisations, programmes and interventions in the meso layer that connect the patterns observed at the micro level with generic policies originating from the macro layer, within a socio-cultural context created by the meta level orientation of the society.

Notes

[1] Classical economists often call these patterns ‘market failures’. Evolutionary economists, however, contest the usefulness of the concept of market failure. Cimoli, Dosi, Nelson and Stiglitz (2006) for example write: “albeit quite common, the ‘market failure’ language tends to be quite misleading in that, in order to evaluate the necessity and efficacy of any policy, it takes as a yardstick those conditions under which standard normative (‘welfare’) theorems hold. The problem with such a framework is not that ‘market failures’ are not relevant. Quite the contrary: the problem is that hardly any empirical set-up bears a significant resemblance with the ‘yardstick’ – in terms of e.g. market completeness, perfectness of competition, knowledge possessed by economic agents, stationarity of technologies and preferences, ‘rationality’ in decision-making, etc. (the list is indeed very long!). In a profound sense, when judged with standard canons, the whole world can be seen as a huge market failure!” (emphasis in original)

References

ANDREWS, M., PRITCHETT, L. & WOOLCOCK, M. 2012. Escaping Capability Traps through Problem-Driven Iterative Adaptation (PDIA). Harvard, MA: Harvard Kennedy School Centre for Global Development.

CIMOLI, M., DOSI, G., NELSON, R. & STIGLITZ, J. 2006. Institutions and Policies Shaping Industrial Development: An Introductory Note. New York: Initiative for Policy Dialogue (IPD) Columbia University.

ESSER, K., HILLEBRAND, W., MESSNER, D. & MEYER-STAMER, J. 1996. Systemic Competitiveness: New Governance Patterns for Industrial Development. London: Frank Cass.

GARUD, R., KUMARASWAMY, A. & KARNØE, P. 2010. Path dependence or path creation? Journal of Management Studies, Vol. 47(4) pp. 760-774.

HOLLINGSWORTH, R. 2000. Doing Institutional Analysis: Implications for the Study of Innovations. Vienna: Austrian Academy of Sciences, Research Unit for Institutional Change and European Integration – ICE.

NORTH, D.C. 2005. Understanding the Process of Economic Change. Princeton, N.J.: Princeton University Press.

RODRIK, D. 2000. Institutions for high-quality growth: What they are and how to acquire them. Studies in Comparative International Development, Vol. 35(3) pp. 3-31.

SYDOW, J., WINDELER, A., MÜLLER-SEITZ, G. & LANGE, K. 2012. Path constitution analysis: A methodology for understanding path dependence and path creation. BuR-Business Research, Vol. 5(2) pp. 155-176.

Markets as social institutions

Markets are places where people come together and where multiple exchanges occur between multiple buyers and multiple sellers with a degree of competition. Institutions are necessary preconditions for markets to work effectively in the long run. Coase emphasises in his Nobel Prize lecture that “without the appropriate institutions, no market of any significance is possible” (Coase, 1992:4). From an institutional perspective, market exchanges are regulated and shaped by laws and regulations as well as local customs and norms. In contrast, in an attempt to find universal principles, classical economists saw the market as a universal mechanism that is not dependent on the conduciveness or even sheer existence of a local institutional setting. The view that institutions play a critical role in market and economic performance has, however, moved to the mainstream of economic thinking over the last three decades (Hodgson, 2008, 2007).

The ‘right’ institutions for functioning markets

Hodgson (2008) in his review of markets in the economic literature finds that the search for the ‘optimal’ rules and institutional forms for markets to work efficiently is difficult or even impossible – a lot depends on the local context. Other scholars, however, have come up with broad categories of institutions that need to be in place for markets to work. These findings should not be seen as hard and fast rules but rather as rules of thumb to better understand market efficiency.

McMillan (2002) found that a workable platform for a market has five specific institutional functions:

  • information that flows smoothly
  • property rights that are protected
  • people must be able to be trusted to fulfil their promises
  • side-effects on third parties must be curtailed
  • competition in the market must be fostered.

Rodrik (2000:5-10) identifies five non-market institutions that are needed for markets to perform which overlap with McMillan’s institutional functions:

  • property rights
  • regulatory institutions
  • institutions for macroeconomic stability
  • institutions for social insurance
  • institutions for conflict management

Rodrik and McMillan agree on property rights, although McMillan emphasises that these rights must not be overprotected. Rodrik’s description of regulatory institutions and their functions combines McMillan’s two elements, namely that side-effects on third parties are curtailed and that people can be trusted to fulfil their promises. The description offered by McMillan seems to rely more on social trust than on law enforcement, while Rodrik emphasises the role of laws and courts. Rodrik does not focus so much on information flows as does McMillan, but discusses competition and its importance elsewhere (Rodrik & McMillan, 2011; Rodrik, 2000).

Competition is central to the functioning of markets (McMillan, 2002). Vickers (1995:1) explains that competition is important for productive efficiency because:

  • competitive pressure makes organisations internally more efficient by sharpening incentives to avoid sloth and slackness
  • competition causes efficient organisations to prosper at the expense of inefficient ones, and this selective process is good for aggregate efficiency
  • competition to innovate is the major source of gains in productive efficiency over time.

Not only firms compete. Public organisations compete for scarce resources and political support. Ideologies or political ideas compete for voter support. Countries also compete in global markets and for global support.

Personal and impersonal exchange

While many primitive forms of market can exist through personal transactions where trust is built by social relations only, many countries are held back by an inability to enable more sophisticated markets based on impersonal transactions (Shirley, 2008; North, 2005). Impersonal transactions occur when people transact with those they do not know, do not necessarily relate to, or will never see each other face to face.

Impersonal exchange depends on a range of institutions that protect the rights of suppliers and buyers. For instance, organisations that promote standards, or laws that protect the rights of suppliers and customers, or regulations that shape how goods are sold, exchanged or replaced in case of damage are important to enable impersonal exchange. Societies that are missing these elements will be limited as to the sophistication of transactions that can take place.

While some of the institutions enabling impersonal exchange can be classified as ‘market supporting’, there are many others that may not be directly related yet are critical, for instance, basic education which enables people to read and write and thus enter into contracts.

Shirley states that markets require two broad kinds of institution to be in place to realise gains from impersonal trade (Shirley, 2008:20):

  • Institutions that foster exchange by lowering transaction costs
  • Institutions that influence the state and other powerful actors to protect private property and persons rather than expropriate and subjugate them.

In conclusion, for a market to work properly as a place where multiple exchanges by multiple buyers take place, a framework of institutions is needed. Competition is central to the functioning of markets. Market transactions, however, do not exist in isolation from non-economic social interactions. Consequently, the social context and culture strongly influence market exchanges.

References

COASE, R.H. 1992. The Institutional Structure of Production.  Occasional Paper Number 28, Chicago, IL: University of Chicago Law School.

HODGSON, G.M. 2007. Evolutionary and institutional economics as the new mainstream? Evolutionary and Institutional Economics Review, Vol. 4(1) pp. 7-25.

HODGSON, G.M. 2008. Markets. In The Elgar Companion to Social Economics. Davis, J.B. & Dolfsma, W. (Eds.), Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing, pp. 251-266.

MCMILLAN, J. 2002. Reinventing the Bazaar: a Natural History of Markets. 1st ed. New York: Norton.

NORTH, D.C. 2005. Understanding the Process of Economic Change. Princeton, N.J.: Princeton University Press.

RODRIK, D. 2000. Institutions for high-quality growth: What they are and how to acquire them. Studies in Comparative International Development, Vol. 35(3) pp. 3-31.

RODRIK, D. & MCMILLAN, M.S. 2011. Globalization, Structural Change and Productivity Growth. Working Paper No. 17143. Cambridge, MA: National Bureau of Economic Research.

SHIRLEY, M.M. 2008. Institutions and Development: Advances in New Institutional Analysis. Cheltenham, UK: Edward Elgar.

VICKERS, J. 1995. Concepts of competition. Oxford Economic Papers, Vol. 47(1) pp. 1-23.

 

Institutions as the rules-of-the-game

Humans have an inherent tendency to reduce uncertainty by structuring their environment. Uncertainty in human interactions is reduced by creating structures that allow people to expect a certain behaviour from others in a specific situation. For example, in a football match, one can expect the players to adhere to the formal and informal rules. The rules of the game constrain what behaviour the players are expected to adopt. They may not, for example, pick up the ball with their hands and run with it to the goal. In the social sciences, the persistent structures that reduce uncertainties in human interactions are called institutions.

Through people’s continuous efforts to reduce uncertainties in their lives, institutional constraints accumulate over time and an elaborate structure of informal and formal institutions emerges. Institutions are ‘the rules of the game’ both on the level of personal interactions but also on the level of interactions among organisations, firms and government. The academic discipline of New Institutional Economics (NIE) is concerned with the institutions, formal and informal, that govern human interactions and exchanges in the economy.

According to North (2005:49), the institutional framework in a society generally consists of:

  • the political structure that specifies the way we develop and aggregate political choices
  • the property rights structure that defines the formal economic incentives
  • the social structure – norms and conventions – that defines the informal incentives in the economy.

More concretely, common institutional arrangements include (Menard & Shirley, 2008:1, in revised order to mirror North’s list above):

  • constitutions, laws and rules that govern politics, government, finance and society more broadly
  • written rules and agreements that govern contractual relations and corporate governance
  • unwritten codes of conduct, norms of behaviour and beliefs.

Scholars differentiate between informal institutions that emerge from human interactions and are not codified but are rather part of the culture in a society and formal institutions as consciously designed and codified governance structures. Informal institutions include social values and norms as well as, for example, informal ways to enforce a contract. Formal institutions include written laws and rules, processes, etc. Institutions are complemented by, and their effectiveness is dependent on, enforcement mechanisms.

At the same time as reducing uncertainties for actors, institutional structures determine how the competitive environment is shaped and, consequently, whether an economy is competitive. Institutions reduce transaction costs and create positive externalities, for example through the coordination of available knowledge in a society, which allows the specialisation of production. North (2005:2) asserts that “The evolving structure of political and economic markets is the key to explaining performance”.

In a sense, institutions perform the function of second-order context-sensitive constraints. They have emerged through the interaction of people, forming the systemic whole of a society or an economy. They enable the economy to work but at the same time constrain the options of each actor within the economy. An example of such a constraint would be a social norm in a specific community only to trade with people of the same religion. The constraint is enabling in as far as it builds trust between a potentially large network of people who do not know each other personally but have the same beliefs. At the same time it constraints the options of each individual.

Resources

MENARD, C. & SHIRLEY, M.M. 2008. Handbook of New Institutional Economics. Springer Berlin Heidelberg.

NORTH, D.C. 2005. Understanding the Process of Economic Change. Princeton, N.J.: Princeton University Press.

 

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