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. 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.
 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)
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