Chapter 4
Theories of
Institutional Change
4.1. Introduction
• Even though rigid, institutions are
subject to change.
• They evolve and change over time
in response to the increasing
complexity of human interaction.
• Institutional persistence &
evolution are guided through
process of reciprocal
interdependencies and
complementarities of behavior
4.1 Cont…
• Coordination among individual
actions is possible if their
actions are complementary to
each other.
• Complementarities of actions
are reasons for stable form of
interaction and predictable
behavior to exist in human
relations.
4.1 Cont…
Why institutions change?
In general term we can state
the following as to why
institutions change:
4.1 Cont…
i) First institutional
Imperfections
Institutions are basically imperfect,
so in order to ‘perfect’ institution
should be change this imperfection
institutions has to evolve over time.
Sources of institutional
imperfections include:
1)They are implemented under
imperfect information and
4.1 Cont…
2)Institutions are created by people
who are not perfectly rational (by
rationally bounded individuals ).
So, institutions evolve as people‘s
understanding of the phenomenon
around them changes.
3) There are asymmetric information
and opportunistic behavior which
negatively affect institutional
efficiency. Hence, institutions have
4.1…
ii) The Second is External
factor – institutions are subject to
external influences that force to
modify or change existing
institutional framework.
4.2 Informal versus formal Institutional changes
• Both formal and informal
institutions are subject to changes
• Informal institutions are change
resistance (very rigid) relative to
formal institutions
• Formal institutions can be viewed
as extensions of informal once.
4.2 Cont…
• In other words, formal
institutions
evolve(implements)to
supplement (over
come )limitations of informal
institutions.
• Hence, Institutional change can
be viewed as movement from
informal to formal institutions.
4.2 Cont…
Evolution of formal
institutions:
• As the complexity of human
interactions increase, informal
institutions become inadequate
to handle it
• For example, development of
long distance trade,
urbanizations, etc, lead to
4.2 Cont…
• These induce introduction of
formal institutions that
would handle the complexity
more efficiently.
4.3 Organizations and Institutional Changes
• Organizations are created to
take advantage of opportunities
provided by existence of
institutions
• Organizations provide
arenas/space in which
institutions are put into use and
tested.
• the experience accumulated in
4.3 Cont…
• These feedbacks from
organizations could trigger
institutional changes or some
form of modifications
• Thus, organizations serve as
agents of institutional change
4.4 Incremental and Path
Dependence of
Institutional Change
i) Institutional change is
incremental
• Institutional change is
incremental because it happen
‘bits by bits’ and large-scale
changes would be difficult.
• The process of institutional change
is overwhelmingly incremental.
4.4 Cont…
• Institutions are essentially rooted
deep into the fabric of society and
their change involve massive
coordination efforts.
• This makes difficult to change
them in one swift blow. Changes
happens bit by bits – and it
accumulates over time and
ultimately leading to fundamental
change
4.4 Cont…
ii) Path dependence
• Institutional change is path
dependent in the sense that past
experiences and/or existing
institutional conditions set the
direction and boundaries of
future changes to be adopted.
• Path dependence refers to set of
constraints that are derived from
historical experiences (or the
4.4 Cont…
• Existing set of institutional and
organizational matrices have a tendency
to produce effects that further fix the
society in the direction - where it
goes, when it goes and how it goes.
• Path dependence indicates, history
matters on what direction of changes a
society choose at any historical period.
“when the past is known, future will be
predictable”
4.4 Cont…
• Complementarities, economies of
scale and network of externalities
associated with institutions will
make institutional change difficult.
Complementaries:- institutions
exist and persist through
complementarities of individual
decisions. Decision made by one will
positively encourage other to do the
same.
4.4 cont…
• Economies of scale :- institutions also
have features of economies of scale.
Institutions will have befits when
accepted by most people. As more
and more people accept a given
institution, it will become more
effective in coordinating behaviour.
• Externality :-
4.3…
• Interests of existing organizations
and groups; and the mental models
of actors tend to `rationalize' in
favor of the existing institutional
setting.
• Path dependence could explain why
nations/ countries diverge in terms of
development
4.4 Cont…
iii) Institutional change and Lock –
in Effects Increasing Returns
•Institutions have features of increasing
returns - the more people accept a
particular forms of institutions the more
effective it will be (in terms of reducing
transaction costs, coordination, social
capital, etc). This the way how
institutions benefits society.
4.4 Cont…
However, existence of Increasing returns
to institutions create lock-in effect (lock
society at suboptimal/inferior outcome)
and makes change difficult:
How?
1) Positive feedback from commitment
to existing Institutions lead to the
selection and persistence of existing
institutions, practices, technologies, etc.
4.4 Cont…
2) Existence of IR (increasing returns),
create coordination failure – because of
the complementary between individuals
decisions, it is difficult for community
members to move simultaneously into the
new – superior - outcome.
3) Deter individual from taking initiative to
change. Individual initiative encounter
social or economic lose, may be labeled as
deviate or hieratic for moving away from
the old.
4.5 Theories Institutional Change
1)Innovation Induced
Institutional change theory
2)Transaction Cost theory
3)Distributional Bargaining
Theory
4) Interest Groups theory
5) Public choice theory
6)Property Rights Theory
4.5 Cont…
1) Theory of Innovation
Induced Institutional
change
• institutional changes are
induced by Innovations or
Technical Progress.
• Technological Innovations
alter relative factor price,
introduce new ways of doing
4.5 Cont…
• These will trigger modification
or change in the existing
institutions.
2. Transaction Cost theory
• institutional change takes place
to further reduce transaction
costs
4. cont…
•Institutions that evolve to
reduce transaction costs are
keys for a good performance of
economies.
•Institutions change
essentially motivated by the
need to achieve a minimum
possible transaction costs.
4.5 cont..
3. Distributional
Bargaining Theory
• the driving force of
institutional change is
distributional conflict over
resources of significant
importance
• institutions are the by-products
of social conflict; conflict over
4.5 Cont…
4. Interest Groups theory
• The theory assumed strategic
relation between politicians and
interest groups through which
institutional change can be effected.
• Politicians want political power and
interest groups are up for
institutional change of particular
form that favors their interest.
• This alliance of politicians and interest
groups drive institutional change
4.5 Cont…
5) Public choice theory
• Public choice theory refers to institutional
change initiated through the political
participation of people there by
influencing politicians and political
parties to make institutional change.
• In the political markets; “Vote is the
currency “, people are ‘buyers of
promise’ to get their demand done; in
return give vote for those who promise to
satisfy their demand.
4.5 Cont…
• While politicians are ’sellers of
promises’ , in the process
optimize their power (get vote –
hence, hold power).
• Through such political process,
institutional change is initiated.
4.5 Cont…
6. Property Rights Theory
• institutional change arises from
a need to re-
structure, redefine and refine a
poorly defined property rights.
• In a society, property rights
determine the parameters for
the use of scarce resources;
and assign the associated
Property Right theory ..
• Property Right is not a
relationship between the
right holder and the object;
• it is a relationship between
the right holder and other
people with respect to the
object.
Property rights…
Property Rights are instrument of
society with a number of
important functions:
1. A primary function of
property rights is to maintain
INCENTIVES and achieve
greater INTERNALIZATION OF
EXTERNALITIES.
• The existence of externality
always associated with vague
Property rights…
2. Property rights help agents to
form EXPECTATIONS which
she/he can reasonably hold in
dealings with others.
3. The way rights are defined
could also determine EQUITY in
resource distributions and
exploitations.
4.5 Cont…
Why property right changes?
• The argument here is change in
property rights induces institutional
change.
• Redefining, reallocation of property
rights involve costs to the society.
• Thus, relevant institutional
frameworks are needed to minimize
the cost of redefining rights and its
enforcement.
4.5 Cont…
There are number factors that
initiate change in property rights:
1. Increased complexity of
Economic interactions
(exchange system and
economic activities) trigger
institutional change.
• In simple economy, complicated
institutional framework dealing
with definitions and distributions
4.5 Cont…
• However, as economic activities
become more complex, pattern
of ownership rights will change .
• sophisticated institutional
framework will emerge to
effectively handle complex
property right arrangements
2. Change in the bargaining
power
• Change in bargaining power will
trigger institutional change.
• The structure of property rights
is defined and determined by
winners and by those who have
the bargaining power.
• Property rights defined is geared
in favor of winners in bargaining
4.5 Cont…
3. Increase in relative scarcity of
economic resources
• As resources become more and more
scarce (could also mean rise in relative
value of resources), degree of specificity
of rights increases.
• That is, property rights become specific as
resources become scarce; such as
movement from common property rights
to private property rights could indicate
increase in specifity of rights.
4.5 Cont…
4. Security of rights – property rights may
change overtime to secure rights in terms of the
bundles of rights, durations and assurance of
rights.
5. Ecological uncertainties: Unpredictable
fluctuations in the natural resource base call for
different sets of rules and rights to deal with
different situations.