INTRODUCTION TO INSTITUTIONAL
AND BEHAVIORAL ECONOMICS
CHAPTER THREE
THEORIES OF INSTITUTIONAL CHANGE
COMPILED BY: LA.(MSC)
At the end of this chapter, students should be able to:
Understand why Institutional change is needed?
Understand Institutional change as
designed(centralized)
The efficiency view
The Power (Distributive) Perspective
Understand Evolutionary/Spontaneous/decentralized
theory of institutional change
Know equilibrium perspective of institutions
Institutional change refers to the process of modifying
or transforming established systems, rules, and
structures within an organization or society
It explains the change of institutions considered as rules
and expectations that govern human interactions and
path of development.
It involves the evolution and adaptation of institutions in
response to various factors, such as shifts in interests,
ideas, and external influences.
According to North, institutional change occurs when
those people who are able to influence policy decisions
perceived the current institutional framework as not
performing effectively with regard to whatever
measures of success they deem appropriate.
If and quickly institutions change also depends on the
adaptive efficiency of the institutional framework.
While some institutions like regulations might change
relatively faster than for example social norms, also the overall
speed of change might be different in different societies.
Some societies are open to change, particularly when the facts
show that change is needed, while others might be generally
more conservative and opposed to change.
But it is then also the internal structure of institutions and
how they interact with each other that influences the speed of
adaptation and change.
North is quite adamant in that institutional change is
predominantly driven by people with influence and power
because they make decisions about policies, rules, regulations
and other institutions that shape the incentive system for
business.
Hence, the more democratic and pluralistic a society is,
the larger the group of people who can participate in
this decision-making process.
But in many cases, there are just a few people in power,
strongly opposing any kind of economic change
because the current situation predominantly benefits
themselves at the expense of the large majority of
people in the country.
Institution create conducive conditions for economic
actors to engage in business and for markets to work,
such as secure private property, an unbiased system of
law, and a provision of public services.
Institutional theory is a discipline to explain both
individual and organizational actions.
A main research field of the institutional theory is the
analysis of how institutions change over time.
As a matter of fact, institutions can shape the nature of
change across different levels and contexts, as well as
themselves change in character, behavior and potency
over time and space.
Why institutional change is needed
Institutional change is often needed to address systemic
issues and inefficiencies within an organization or society.
Here are some key reasons why institutional change may be
necessary:
1. Inefficiency and Ineffectiveness: Existing institutions may not
be achieving their intended goals. For example, outdated
policies or structures in a company might lead to poor
performance or missed opportunities.
2. Inequity and Injustice: Institutions may perpetuate
inequality or injustice. For instance, discriminatory practices in
hiring or legal systems can lead to unfair treatment of
individuals.
3. Adaptation to Change: Societies and organizations must adapt to
changing circumstances. Technological advancements, economic
shifts, and demographic changes require updates to institutions to
remain relevant and functional.
4. Corruption and Mismanagement: Institutions may suffer from
corruption, lack of accountability, or mismanagement. Reform is
often necessary to restore trust and ensure proper governance.
5. Lack of Innovation: Institutions that resist change may become
stagnant and unable to innovate. Encouraging institutional change
can foster creativity and new approaches to problem-solving.
6. Public Demand for Reform: Citizens or stakeholders may demand
changes due to dissatisfaction with current conditions. Governments
and organizations often need to reform to meet these demands and
maintain legitimacy.
7. Globalization and Competition: In a globalized world, institutions
must evolve to remain competitive. Businesses, for example, need to
adapt to global market trends and regulatory environments.
8. Legal and Regulatory Changes: New laws and regulations may
necessitate changes in institutional structures and practices to ensure
compliance and avoid penalties.
9. Crisis Management: Crises such as economic downturns, natural
disasters, or public health emergencies often highlight the need for
institutional reforms to better manage and mitigate impacts.
10. Ethical Considerations: Ethical concerns can drive the need for
institutional change. For example, shifts in societal values regarding
issues like privacy, labor rights, and environmental protection can
necessitate reforms.
In summary, institutional change is essential for
improving efficiency, equity, adaptability, and
overall effectiveness.
It helps address systemic issues, fosters
innovation, and ensures that institutions remain
relevant and responsive to the needs of their
stakeholders.
Different Theories of institutional changes
The followings are different types of Theories
of institutional changes
Evolutionary/Spontaneous/decentralized
institutional change
Institutional change as designed (centralized)
The efficiency view
The Power (Distributive) Perspective
Equilibrium perspective of Institutions
3.1Evolutionary/Spontaneous/decentralized institutional change
Spontaneous institutional change refers to the natural
and organic evolution of institutions over time.
This type of change occurs without any deliberate
intervention or design.
It is driven by factors such as social, economic, and
political forces, as well as the interactions and
behaviors of individuals within the institution.
Spontaneous institutional change can result in the
emergence of new institutions or the transformation
of existing ones.
Theories of evolutionary institutional change suggest that
institutional change is due to human actions, such as
learning, imitation, etc.
The difference between evolutionary and designed-based
theories is the role of the selection process determining
which rules emerge and adapt in socioeconomic
environments.
Evolutionary theories do not consider a central
mechanism (e.g., legislation) that causes a coordinated
shift in the rules perceived by behavior or beliefs of
players.
New rules or behaviors are due to a decentralized
selection process and, as a consequence, successful
institutions adapt and growth in society, whereas
unsuccessful institutions do not survive.
In brief, new rules and patterns of behavior emerge
from the uncoordinated choices of many individuals,
rather than collective-choice or political processes.
Overall, then, evolutionary theories and the design-based theories
consider exogenous parameter changes as a prime factor of
institutional change.
Veblen (1899) argues that changes in population and technology
guide institutional change by ensuring that current institutions and
habits of thought, inherited from the past, are never ideally suited
to the requirements of the present.
Hence, institutions and habits are continually evolving: the
evolution of society is substantially a process of mental adaptation
on the part of individuals under the stress of circumstances.
In short, evolutionary theories neglect the role of collective action
and political process, and designed based theories have difficulty
in explaining changes in informal rules, which evolve in a
decentralized manner.
3.2 Institutional change as designed (centralized)
In contrast to spontaneous institutional change,
institutional change can also be intentionally
designed and implemented.
This approach involves deliberate efforts to alter
or improve institutions through planning,
decision-making, and action.
There are different perspectives on how
institutional change can be designed effectively.
3.2.1 The Efficiency Way
One perspective emphasizes efficiency as the primary goal
of institutional change.
This approach focuses on identifying and addressing
inefficiencies within institutions and finding ways to
optimize their performance.
The efficiency way to institutional change involves analyzing
the current state of the institution, identifying areas for
improvement, and implementing changes that enhance
efficiency.
This perspective often relies on economic principles and
quantitative methods to evaluate the impact of institutional
change.
3.2.2 The Power (Distributive) Perspective
Another perspective on institutional change emphasizes
the distribution of power and resources within institutions.
This approach recognizes that institutions are shaped by
power dynamics and social inequalities, and seeks to
address these issues through institutional change.
The power perspective on institutional change focuses on
redistributing power and resources to promote social
justice and equity.
This approach often involves challenging existing power
structures and redistributing resources to marginalized
groups or communities.
Both the efficiency way and the power
perspective offer valuable insights into how
institutional change can be designed and
implemented effectively.
By considering different perspectives and
approaches, institutional change can be
tailored to meet the specific needs and goals of
a particular context.
In this approach, institutional change is a
centralized and collective choice process in which
rules are explicitly specified by a collective
political entity, such as the community or the
state, and individuals and organizations engage in
collective action, conflict and bargaining.
The process of institutional change is that:
each individual calculates their expected costs
and benefits from an institutional change, and if a
‚minimum coalition necessary to effect change
agrees to it, an institutional change can occur.
A minimum coalition is determined by higher-level rule,
such as in a democracy, a majority would constitute a
winning coalition.
Alston, (1996) outlines that: Institutional change can be
thought of as the result of supply and demand forces in a
society. We can think of demanders as constituents and
suppliers as the government ... Institutional change
results from the bargaining actions of demanders and
suppliers.
From where does the impetus for institutional change
come from? Libecap regards exogenous parameter(like
tecnological change and preferences) shifts as the basic
cause of institutional change. i.e. the distribution of
benefits both under the existing and proposed new
systems.
Ostrom (2005) argues that if the beneficiaries of
institutional change cannot commit to compensate the
losers, powerful groups may be able to block beneficial
change or impose inefficient change.
A further impediment to efficient institutional change is
the bounded rationality of players: some or all players
may hold incorrect beliefs about the likely effects of a
proposed institutional change.
Levi (1990) emphasizes that formal rules can give
“power” to certain groups, and that disadvantaged
groups may try to force institutional change by
“withdrawing their consent” from existing institutional
arrangements
In general, since inefficient institutions can persist, and
institutional change is usually incremental, it is often
easier to achieve consensus on small adjustments than
to effect major changes to existing rules.
However, these theories, based on institutional change
as the outcome of a deliberate, collective-choice process
of rule-creation, may not explain why formal rules fail to
produce their intended outcome.
2.3. Theories of the equilibrium view of institutions
The approach of Equilibrium Perspective endeavors to
treat formal and informal rules within a unified
framework by shifting the focus from the rules
governing behavior to the behavior itself.
In fact, the Equilibrium Perspective of institutions
considers the essential role of both formal and informal
rules as devices that enable players to coordinate on
one of these many equilibrium by helping them to
achieve a shared set of beliefs about each other’s
behavior both on and off the path of play.
In the Equilibrium Perspective, institutional change is
due to changing expectations, rather than changing
rules.
Moreover, theories based on institutions as rules
consider the enforcement of rules separately from their
content; in the Equilibrium Perspective, in contrast,
enforcement is endogenous.
Exogenous parameter shifts, such as changes in
technology or preferences, can disrupt equilibrium,
leading individuals and organizations to change the
‚formal rules‛ in order to achieve a coordinated shift of
many players beliefs about each others’ strategies.
Comparison between organizational and institutional
change
Organization Institution
Factors for Changes in the Change of the rules
change competitors’ -New rules
environment, Resource, occurrences
competition, demand and Rules fall out
supply Change of the
Preferences changes(new methods for setting
substitutes) rules
Change in the Change in the
technological technological
environment environment