Chapter 6:

Institutional changes in the process of

development.
Introduction
• Little is done in economic science and, more
specifically, in institutional theory in the area of
institutions planning, controlled replacement of one
institutions by the others and the choice of prevailing
condition of institutional dynamics (“dependence on the
past”, “independence on the past” or partial dependence
on the past).
• The majority of macroeconomic models proceeds from
the minimum impact of the institutions on economic
dynamics and decision-making.
• They do not especially consider the stylistics of
institutional changes, both of internal, and external
nature (transplantation and institutions adoption).
4/11/2025 1
 Introduction cont---
• In the modern economy, at least, in the most
developed countries, the frequency of institutional
changes and political decisions provoking such
changes considerably outstrips the possibilities of
the agents to carry out action and tasks in view
and to achieve some result.
• Therefore, introducing any institution, planning or
adopting it, is necessary to consider the reactions
of agents and other institutions which are
designed to cooperate with the introduced
institution.
4/11/2025 2
 Cont--
• The causal sequence of change
Mental models and ideologies (beliefs)

Institutional framework of polity and economy

Incentive structure

Organizations

Policies

Performance
4/11/2025 3
 Institutions are not stagnant, but change over
time
 The way they evolve or change may vary between
different types of institutions
 Institutional change occurs either from below or from the top
 Some authors argue that institutions emerge spontaneously in
the process of repeated interaction among individual or group
of actors
 Others emphasize the intentional design of institutions

4/11/2025 4
 A) Spontaneous institutional change
 When individuals continuously interact a pattern of interaction emerge
which yield some sort of rules that govern their interactions
 At any point in time the durability of existing institutions is questionable,
and the institution might be given up.

 If the more overall institutional structure is challenged, we may observe

radical changes

 Changes that are purely from below are more gradual – step-by-step
changes.

 A typical example is the changing dress codes which can be observed

over time.

4/11/2025 5
 B) Institutional change as designed

 There are two reasons for supporting the view that

institutional change may also be intentionally
created.

 First, some types of change become possible that

will
be beyond the reach of spontaneous.

 Second, any institution regulating conflicting interests

depends on the intentional creation of the law.
4/11/2025 6
 Concepts of Institutional Change

Defn.: Rules of societies change over time

[Link]. of Formal and informal institutional changes

➢ Education policy change Formal

➢ VAT declaration institutions
➢One teacher from grade 1-4
➢Cost sharing for University education
➢ land right

7
➢ Sending women to school
➢ Cultural beliefs of communities Informal
➢interracial marriage institutions
➢Local conflict resolution ,etc

8
Why do institutions change?

-Imperfect information while designing institutions

-new information leads to new understanding of situations

…. leading to demand for new arrangements/rules

-The benefit of new institutions > the old institutions

•change is an event that occurs when something passes

from one state or phase to another

9
 Institutional Change: Agents, Sources,
Process, Direction

❖ Institutions are rules of the game and agents are

the players

❖ Sources of change?
▪ Entrepreneurs/ market initiated
▪ Change in political system/revolutions
▪ judicial changes stemming from court decisions
▪ constitutional rule changes
▪ Any other?

10
❖ Process of change:

- Formal institutional change will occur at those margins

considered most pliable in the context of the bargaining
power of interested parties.

- Informal institutional change occurs with gradual

adoption of a new one as the nature of the political,
social, or economic exchange gradually changes.

- usually informal institutions take longer time to change

than formal institutions.

11
❖ Direction of change:
- Is path dependent
- How things used to be affect how things will be.
- the ideology and interest of actors determine the
direction
- E.g. politics based on race (Ethiopia), religion (Arab
countries), economic power (USA)

12
 Types of institutional changes
• 6.1. Path Dependence. (Dependence on the Past)
• When a new product is made in the firm on the basis of the
available fixed capital and technological possibilities, or a new
mode of rules regarding functioning or units interactions,
interfaced to the former rules or the director’s directions and
following them, is introduced, it is an example of the
development dependent on the past.
• Then, it is possible to present the new condition of the
firm/system as a certain initial condition plus the change which
either can have non-random character and be a result of
peculiar institutional planning, or can have random character.
• If at the country’s level the legislation change is carried out
with the account of the former norms, the new norms logically
grounded follow from the available institutions, it is an obvious
model of the development dependent on the past.

4/11/2025 13
 Dependence path ----
• If the agent leaves the family, thereby, destroying economic
and organizational structure, and creates a new family, but
not only financially supports the former one, but also takes
care of children left, keeps in touch with the former wife,
though during short contacts, it is an obvious model of the
system’s development dependent on the past.
• In the case, when the agent leaves the family and does not
know even about the destiny of the children left, this
scenario is obviously an example of independence on the
past.
• Certainly, there are such models in the society, but it is a
question if they prevail. Most likely, this question is
important from the point of view of prospects estimation of
public system movement, but to answer it is difficult
enough without recourse to the methods of sociological,
psychological, and also historical analysis
4/11/2025 14
 Cont--
• From the point of view institutional analysis it is
advisable to estimate the development trajectory and
the state of institutions in each particular case. And it
is desirable to apply unified estimation criteria for
different countries, firms, organizations and
institutional systems.
• While planning institutions, it is important not only
to provide a mode of , say, independence on the past
or partial dependence, but to consider the time of
institution introduction, the moment of the highest
efficiency of this institution and the necessity of
future correction or replacement of the institution
after a certain time.

4/11/2025 15
 6.2. Path Independence (Independence on the Past)
• Under conditions of market competition, the situation,
when the firm closes down separate productions and opens
absolutely independent area or workshop creating a
product with which the firm enters the market, will mean
the form or model of the development independent on the
past, as absolutely other funds and the personnel are used
in this workshop, and the product is not stereotypic for the
firm.
• If there is a change of ownership in the country from the
public property to the private one (it is the question of
superiority and prevalence of one institution over the
other), it is possible to speak about the basic change of
economic development and the change of institutional
form of the development
4/11/2025 16
 Independence path ---
• In this case the socialist form of development
changes to the capitalist one, presupposing private
property supremacy on the means of production over
other kinds of property, including the public one.
• Collectivist institutions are replaced by
individualistic institutions, with all the following
consequences for agents’ motivation and economy
structure.
• The public sector is reduced, the private one
increases usually for the account of resources of the
public sector. A number of fetishes, ostensibly
having scientific grounds, namely a myth about
competition efficiency, is brought home to agents’
consciousness.
4/11/2025 17
 Cont--
• Institutions are adapting to the conditions of such
mythologization. Why a myth? Because a competitive model
exists only in the “the blackboard theory”, which does not take
into account the institutions and creates absolutely unfeasible
structures, like homogeneous product and a large number of
sellers and buyers.
• In reality, there are not many manufacturers and even traders of
homogeneous product. Arising product variety and, besides, the
impact of mass media eliminate the principle of consumer’s
independence and actually model the demand and create it for
itself.
• Hence, the consumer becomes dependent on circumstances and
institutions, and competitive model is a fiction which is difficult
to imagine even existing on the paper as firms possess unequal
funds (according to deterioration, structure, condition,
productivity and etc.), unequal personnel (according to
qualification), intellectual capital and etc.
4/11/2025 18
 Cont---
• The principle of independence on the past is realized
within the limits of certain administrative (political)
decisions which break the link with the old
institutions, reject them for some reasons and
introduce the norms, apparently, in no way
connected with them.
• Actually, even the absence of any link means the
presence of link by means of decision-making
institution. After all, the rupture does not arise by
itself. Usually, in this case, it is projected by making
of corresponding decisions for the specified model
of institutional developments and trajectory of
independence on the past.

4/11/2025 19
 6.3. Path Determinacy (Partial Dependence on the Past)
• How should the trajectory of partial dependence on the past be
presented? Most likely, for a firm it means creation of new
products on the basis of the updated funds, additional involved
personnel that will allow creating a new product and developing
the new markets. Besides, the firm preserves fundamental rules of
the work without changes.
• With regard to the country, that is, a big economic system, the
vestiges of the previous structure or formation remain. By the way,
thereby, structural approach, whether obvious or not, but assumed
the presence of such trajectory of development, that is dependent
on the past or partially dependent. As it is difficult to define the
degree of dependence, it is necessary to have quantitative criteria.
• And owing to the fact that the public system is very complicated, it
is problematic to pick up unified and aggregated indicators. Then,
in essence, the specified principle of path determinancy is a version
of the dependence principle from the past because there is such a
dependence, and the problem is in the definition of the dependence
degree.
4/11/2025 20
 6.2. Interpretation of economic development as a
process of institutional evolution

• What does the term “past” mean? Is it the

previous period? Obviously, no. It is not simply
the previous period, but the whole development
period during which the society has accumulated
certain knowledge and institutions.
• Of course, to obtain a certain model of
institutional development, it is possible to choose
the time period for analysis. From the position of
such interval introduction it is pertinent to speak
about the period preceding the institutional
changes considered

4/11/2025 21
 Cont--
• At the same time, at singling out the development
periods and, in essence, classifying them in the form
of periodization (for example, with reference to
technics development, technologies, key economic
branches, energy resources and institutions), there
will always be a dependence on the past, but the scale
of changes and new possibilities arising on the basis
of new technologies and technical devices create the
impression of independence on the past, and similar
changes arising are described with enthusiasm in
scientific literature as “technological revolutions”.
• But these so-called revolutions are prepared by all the
experience and knowledge concentrated on certain
directions of production.
4/11/2025 22
 Cont---
• What costs does this or that trajectory of institutional
development give? Does it reduce their institutional
planning and in what degree is the dysfunction of
institutions and economic systems caused by this or that
condition of institutional development and its trajectory.
There simultaneously appears the problem of systems
and institutions dysfunction decrease, including the
decrease at the expense of institutional planning.
• If we introduce the estimation of the system (institutions)
state according to a parameter or group of parameters Sn,
supposing, that this is a new state, and consider the
previous state to be So, it is possible to write down:
Sn = So + Sp + ε,
• where Sp - the increment in the system/institution
according to state parameter; ε - accidental disturbance in
the system.
4/11/2025 23
 Cont--
• In the case of dependence on the past, value Sp is
not large, and So is large in the presented formula,
so it is possible not to take increment Sp into
consideration, that is, Sn = So + ε. In the general
case the formula is complete, even at dependence
on the past.
• If there is a mode of independence on the past,
then So =0, that is, the previous state affects in no
way and does not matter for the further system’s
functioning, and only increment at institutions Sp
and the accidental, stochastic changes specified
by ε are significant.
• For path independence we have: Sn = Sp + ε, at
very strong dependence on the past.
4/11/2025 24
 Cont--
• It is possible to expect, that the stochastic
component will be minimal, so that in the
general view it can be neglected (for example,
a special mode, under conditions of centralized
planning) and then:
• Sn = So + Sp.
• The lower the dependence on the past, the
higher the increment Sp. The higher the
dependence on the past, the lower the value Sp.

4/11/2025 25
 Institutions and Economic Theory
 Institutions are formed to reduce uncertainty by structuring human interaction,
but !here is no implication that the results are efficient, as that term is used
by economists. At issue are both the meaning of rationality and the
characteristics of transacting that prevent the actor; from achieving the joint
maximization result of the zero-transaction-cost model.
 The instrumental rationality postulate of neoclassical theory assumes that the
actors possess information necessary to evaluate alternatives correctly and in
consequence to make choices that will achieve the desired ends. In fact, such a
postulate implicitly assumes the existence of a particular set of institutions and
costless information.
 If institutions play a purely passive role so that they do not constrain the
choices of the players and the players are in possession of the information
necessary to make correct choices, then the instrumental rationality postulate is
the correct building block.

4/11/2025 26
 Just as the efficiency of an economic market can be measured
by the degree to which the competitive structure, through
arbitrage and efficient information feedback, mimics or
approximates the conditions of a zero-transaction-cost
framework, so an efficient political market would be one in
which constituents accurately evaluate the policies pursued by
competing candidates in terms of the net effect on their well-
being; in which only legislation (or regulation) that maximized
the aggregate income of the affected parties to the
exchange would be enacted; and in which compensation to
those adversely affected would ensure that no party was
injured by the action.

4/11/2025 27
• To achieve such results, constituents and legislators would
need to possess true models that allowed them to accurately
evaluate the gains and losses of alternative policies;
legislators would vote their constituents' interests-that is, the
vote of each legislator would be weighted by the net
gains or losses of the constituents, and losers would be
compensated so as to make the exchange worthwhile to
them-all at a transaction cost that still resulted in the
highest net aggregate gain
4/11/2025 28
 If, on the other hand, the players are incompletely informed,
devise subjective models as guides to choices, and can only
imperfectly correct their models with information feedback, then a
procedural rationality postulate is the essential building block for
theorizing. Such a postulate not only accounts for the incomplete
and imperfect markets that characterize much of the present and
the past world, but also leads the researcher to the key to
what makes markets imperfect-the cost of transacting.
 The cost of transacting arises because information is costly and
held asymmetrically by the parties to exchange. As a result,
however the players develop institutions to structure human
interaction results in some degree of imperfection of the markets.
In effect, the incentive consequences of institutions provide mixed
signals to the participants, so that even in those cases where the
institutional framework is more conducive to capturing the gains
from trade than an earlier institutional framework, there will be
incentives to cheat, free ride, and so forth that will contribute to
4/11/2025 29
market imperfections.
 The success stories of economic history describe institutional
innovations that have lowered the costs of transacting and
allowed more of the gains from trade to be captured,
thereby permitting the expansion of markets. But such
innovations, for the most part, have not created the
conditions necessary for the efficient markets of the
neoclassical model.

4/11/2025 30
 The key features of this analytical frameworle of institutional change:
 1. The continuous interaction between institutions and organizations
in the economic setting of scarcity and hence competition is the key
to institutional change.
 2. Competition forces organizations to continually invest in skills and
knowledge to survive.
 3. The institutional framework dictates the kind of skills and
knowledge perceived to have the maximum payoff.
 4. The mental constructs of the players, given the complexity of the
environment, the limited information feedback on the consequences
of actions, and the inherited cultural conditioning of the players,
determine perceptions.
 5. The economies of scope, complementarities, and network
externalities of an institutional matrix make institutional change
overwhelmingly incremental and path dependent.
4/11/2025 31
 The Evolution of Institutions for Collective Action

 What is collective behaviour?

 Any event during which a group of people engages in
unusual behaviour – that is, ‘non-normative’ behaviour
 Behaviour that falls outside the usual, ‘normative’
expectations for behaviour
 Norms – the rules regulating people’s behaviour in
particular situations – they are situation-specific, and
may over time become institutionalized (folkways,
mores, laws) e.g. riots, fads, fashions, social movements

4/11/2025 32
 Principal-Agent Problem
 Agent: an individual employed by a principal to achieve the
 principal’s objective
 Principal: an individual who employs one or more agents to
 achieve an objective

 Problem arises when agents (e.g., a firm’s managers) pursue

 their own goals rather than the goals of the principals (e.g.,
 the firm’s owners).

4/11/2025 33
 Mechanism Design
 Explicitly recognizes the possibility of institutional
failure
 Asymmetric information:

– Moral hazard/Hidden action

– Hidden information
 Adverse selection

 Signaling

 Strategic Behavior and False Signals

4/11/2025 34