Chapter three

Theories of institutional change

Barack Obama once said “Africa does not need

strong men, it needs Strong institutions”.

So, I may rephrase Obama’s statement and say

“Africa does not need Strong men but needs
Strong leaders who can build strong
institutions”(Olanrewaju Omoya ,2018)

P.P by Instructor : Bizuayehu A.(MSc)

 Introduction
• Institutional change explains the
change of institutions considered as rules
and expectations that govern human
interactions and paths of development in
society
• Institutional change means a written
notification of a change at an approved
institution. These changes may include a
change in ownership, address, institution
name, leadership or status.
• Designing for Institutional
Change
[Link] your mission and
vision.
[Link] organizational structures.
[Link] strategic.
[Link], collaborate, and engage.
[Link] systemic change.
[Link] Your Campus Culture.
(these are preconditions)
 Institutions and theories of institutional change: an historical overview

3.1 Designed-based theories of institutional change

 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.
 Libecap (1989) analyzes the sources of “property rights” rules and
considers rule-changing activity as “contracting”: a game governed
by a higher level of political rules, and these higher-level rules,
together with the activities and perceptions of actors, can shape
the direction of institutional change of the lower-level (property
rights) rules.
 Cont’d
 Libecap (1989) also claims that institutional change is a “path-
dependent” process: the institutions may be a function of current
technology, but also of precedent institutions and technologies
• 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.
 Cont’d
• 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.
• Therefore, in these approaches by Libecap (1989) and by Ostrom
(2005), an institutional change depends on higher-level rules and
on how the decision makers perceive the likely effects of a
change in 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.
 Institutions and Efficiency

• There have documented huge differences in total

factor productivity across countries.
• What determines these differences?
• One answer is provided by the combination of the
Romer model and the leader-follower model.
• According to these models, large differences in TFP
reflect variations in the extent to which countries
have adopted the latest technologies. However,
this is perhaps too mechanistic a view of what
generates cross-country differences in efficiency.
• TFP doesn’t just reflect the technologies a country’s
people use.
• It is a measure of the efficiency with which an
economy makes use of its resources and there are a
whole range of other factors that can affect this.
 Cont’d
 For example:
 Bureaucratic Inefficiency and Corruption:
Satisfaction of bureaucratic requirements and bribing
of officials can be important diversions of resources
in poor economies.
 Crime: Time spent on crime does not produce
output. Neither do resources devoted to protecting
inviduals and firms from crime.
 Restrictions on Market Mechanisms:
Protectionism, price controls, and central planning
can all lead to resources being allocated in an
inefficient manner.
• In addition, while technology adoption certainly has
an impact on differences in TFP, this still leaves open
the question of what drives the pace of technology
adoption in poorer countries.
 The Power (Distributive) Perspective

• Institutional power is the ability of

institutions, such as governments, corporations,
or houses of worship, to exert control over
people and their behaviors through systems of
punishments and rewards.
(eg. Logo of
court)
• Power is distributed and exercised in the
general interests of society as a whole, Although
some groups will be more powerful than others,
this is necessary (functional) because the
achievement of collective goals requires
organization and leadership based on power.
 Cont’d

• The institutional perspective covers

policy perspectives, leadership, management
and professionalism at both the country and
company level.

• As we explain later, elements of our

paradigm reflect directly these fundamental
principles and also provide underpinning
assumptions for our proposed structure.
 3.2 Evolutionary theories of institutional change

• Many scholars analyze institutional change as an

evolutionary process (Kingston and Caballero, 2009).
• 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.
 Cont’d
• In brief, new rules and patterns of behavior emerge from
the uncoordinated choices of many individuals, rather
than collective-choice or political processes.
• Evolutionary theory of institutional change by Veblen
(1899) considers the concept of “habits of thought”,
where habits are durable and long-run adaptable
propensities to think and act in particular ways.
• He also argues that: “the evolution of social structure
has been a process of natural selection of
institutions” – that is, a process of “natural selection of
the fittest habits of thought”, both through the
“selection of individuals endowed with the fittest
temperament”, and through the “adaptation of
individual temperament and habits to the changing
environment through the formation of new institutions”.
 Cont’d

• Institutional change here is the simultaneous co-

evolution of both shared prevalent habits of thought
(institutions) and habits of individuals.
• Therefore, the current habits of thought, both shared
and individual, are “received from the past”,
affected by the present, and together they jointly
affect the future path of institutional change (cf.,
Brette, 2003)
• In short, evolutionary theories neglect the role
of collective action and political process, while
theories which view institutional change as the
outcome of a centralized collective-choice process
have difficulty explaining changes in informal rules
(e.g., social norms) which evolve in a decentralized
manner.
 3.3 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 (Aoki 2001;
Calvert 1995; Greif and Laitin, 2004; Myerson, 2004).
• Calvert (1995, pp. 22-23) claims that: “Institution is just a
name we give to certain parts of certain kinds of
equilibria.” Institutions are identified with these
equilibrium patterns of behavior rather than rules
that induce the behavior.
• 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.
 Cont’d
• 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.
• Greif and Laitin (2004) highlight the importance of
endogenous institutional change and introduce the
term “quasi-parameters”, which are exogenous in the
short run, but which gradually change as a result of
the play of game, such as the income distribution,
or the information available to the players. Hence,
changes in quasi-parameters generate institutional
change.
 3.4 The theory of transaction cost

• Thus transaction costs refer to the costs

originating from the various actions taken to reduce
the risk of transaction failure.
• Transaction costs therefore the value of
resources devoted to
• (1) establish and enforce exclusive property rights
and/or
• (2) define and enforce the attributes of the good or
service being exchanged and
• (3) the losses incurred because of failure to
(a) enforce exclusive property rights,
(b) enforce required attributes, or
(c) complete the transaction.
 Cont’d

• The point we want to show in the above hypothetical

case is that most transactions from simple purchase
of good to complex contracts involve positive
transaction costs.

• The 'real world' is beset by positive transaction

costs — on which account the assignment of property
rights and choice of governance structures do matter.

• Assuming that positive transaction costs are not so

great as to block the assignment of property rights
altogether, then differential transaction costs will
warrant the assignment of property rights one way
rather than another.
 Cont’d
• Similarly respect to organization: except
where positive transaction costs block the
organization of some activities altogether,
differential transaction costs will give rise to
discriminating alignment — according to
which some transactions will (for efficiency
purposes) align with one set of governance
structures and other transactions will align
with others.
• In some, transaction costs will have a lot of
bearing on the allocation, production and
distribution activities.
 Cont’d
• Note that when we refer cost in
economics, we are referring to
opportunity costs not just the
financial/accounting costs.
• We don’t consider only the direct
money expenditures rather we
estimate the opportunity costs of the
resources (including the agents’ time)
devoted in realizing the transactions.
• This is the correct meaning of cost in
economics.
 Cont’d
• The concept of transaction costs is the
foundation of New Institutional
Economics.
• As Ronald Choase pointed out, the
organization of transactions, with the
inevitable costs it incurs, determines what
goods and services are produced and the
capacity of any economy to take advantage of
the division of labor and specialization – the
two key concepts of economic theory since
Adam Smith.
• Thus, transaction costs profoundly influence
not just individual firms but the size and
activities of the entire economy.
 Cont’d
• The extent of transaction costs thus
determine the level and types of
economic activities.

• The extent of transaction costs then depend

on the institutional environment that
determine: the degree of information problem
(on prices, new technologies, and other
potential market players), the extent of
opportunism, the strength of defining and
enforcing property rights and contract and the
level of risks posed by exogenous shocks.
 Sources of transaction costs

 Information and search costs

• As we discussed in earlier chapters, in perfectly
competitive markets economic agents are
assumed to have perfect knowledge.
• The presumption is they can access whatever
information they need without incurring
considerable costs. But in reality information
are not only imperfect but also involve costs.
• In addition, human being has limited ability
to gather and process information. The
implications are that economic agents devote a
lot of resources to gather information.
 Cont’d
• In the above example, determining the amount of
payment require a lot of information such as future
relative prices, the level of payments in other
areas for similar agreements (if there is), estimation
of each other’s potential gains, and the like.
• More importantly, each agent must collect
information about each other’s trustworthiness,
reputations, past history, social status, network, and
the like.
• Searching appropriate partner there are two or more
alternative partners) also require a lot of efforts.
• All these tasks involve costs that would otherwise
been used for productive activities elsewhere in
the economy.
 Cont’d
• Bargaining and decision costs
• Having equipped with the required information,
the transacting parties must make a lot of bargaining
in order to reach at profitable terms of agreement.
• Depending on the complexity of the transaction, this
can involve a lot of resources –lobbying, financing
meetings, payment for third party mediating the
bargaining, and the like.
• To achieve favorable terms and avoid possible risks,
parties will have to devote time and resource in the
bargaining.
• Once agreement is reached on general and key
issues, drafting, reviewing and signing the agreement
is not a simple task. It can involve a lot of cost.
 Cont’d
• Supervision and enforcement costs
• Once the agreement is signed, each party
need to monitor the other.
• Still this can take a lot of surveillances,
supervision, hiring consultants or forming an
independent organ, etc.
• Enforcing when there are deviations could also
involve a lot of costs.
• This can be through legal court or through
informal ways.
• In short we can find these three classes of
transaction costs in many economic
exchanges.
 Cont’d
• For instance hiring a worker require finding a
suitable worker, examining potential applicants,
bargaining on the wage rate, assessing the prevailing
wage rates, metering performances (marginal
contributions), designing appropriate incentive
structure, penalizing shirking and malfeasances, and
the like.
• Why firms need supervisors?
• It is because workers may shirk, underperform, abuse firms
resources, and the like.
• Therefore, The various resources to devoted for
management activities can be considered as
transaction costs that would have been used for
other productive activities.

THE END