Debre Birhan University

Department of Economics
Lectures on
Introduction to Institutional and Behavioural Economics

Econ 4161
Instructor : Girma M. (M.Sc.)

Email:- mgirmamulu12@gmail.com
March ,2024
Chapter 3: Theories of institutional change

Contents of the chapter

3.1. Spontaneous institutional change

3.2. Institutional change as designed
3.2.1. The efficiency view
3.2.2. The Power (Distributive)Perspective

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 Introduction to Institutional Change Theory
Institutional change explains the change of institutions
considered as rules and expectations that govern
human interactions and paths of development in
society.
Power and politics are central in understanding
institutional change and persistence.
Institutions do not function in a vacuum but interact
with other institutions.
Institutional change is driven by the demands of
organizations that seeking to reduce transaction costs.
Institutional theory is a discipline to explain both
individual and organizational actions. A main enquiry
field of the institutional theory is the analysis of how
institutions change over time. 3/21/2024 Girma M. 3
 ​I nstitutions 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

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A) Spontaneous institutional change
When individuals continuously interact a
pattern of interaction emerge which yield
some sort of rules that govern their
interactions
Next, the institution is expanded to other
people who copy or reproduce.
This process of copying can be explained in
three different ways, where two of them also
involve intention at this stage.

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the act may be copied because of some
conformism – that is, based on some
tendency by humans to just do as others
do.
it may be picked up because – after we
have considered it – we also find the
solution sensible or good for us.
the reproduction may be the result
of some authority relation

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 ​Atany 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-b y - step changes.
They are evolutionary
One can recall the concept of mutation in
biology to describe the creation of an
alternative behavioral pattern.

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 ​ But here “mutations” often originate in
changed attitudes or preferences.
 This formation of an alternative solution
becomes an institution when others imitate
it.
 Learning and copying replace the biological
type of selection or one can call it “social
selection”
 A typical example is the changing dress
codes which can be observed over time.
 Dressing styles change as a result of
intentional design by manufacturers or based
on individual preferences

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These theories are advocated foremost by the
institutions-as-equilibria position and often
cast in a game-theoretic language.
It is a type of s o-called evolutionary game
theory.
The focus here is on how equilibria are
spontaneously developed and changed into
new types of equilibria.
This specific position looks at the
individual as boundedly rational and
considers knowledge to be subjective

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Preferences are, however, considered stable
Therefore this school is closer to standard
neoclassical economics
By pursuing evolutionary game theory, they
suggest that individual behavioral deviations
(„errors‟) are the „mutations‟ which create
options for new institutions.
Thus, they come closer to the biological
model of evolution

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There are criticisms however.
While the theory of pure spontaneous
emergence can help to explain how most
informal institutions emerge and change,
it can't convincingly explain changes in all
institutions
For instance, it can adequately apply to
language but not to the evolution of money
Language is the archetype of a spontaneous
institution since its rules are in fact self-
policing.

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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 or „from below‟
processes as defined here.
These are typically changes involving some sort of
collective decision, which can transcend not least the
large transaction costs involved in individual
bargaining.
Second, any institution regulating conflicting
interests depends on the intentional creation of the
law.

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a) The efficiency view
The idea that institutional change is efficiency
determined is advocated mainly by the new
institutional economists.
Actually there are two types of issues that are
dominantly focused on when arguing that
institutional change is efficiency driven.
First, institutional change enhances efficiency
by economizing on transaction costs.
Second, institutional change enhances
efficiency by fostering technological change.

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i) Institutional Change to Reduce Transaction
Costs
The idea of transaction costs reduction
is used to explain many different types of
institutional structure
There are three focal ones: the existence of
property rights, the creation of firms and the
existence of the state.
Property rights imply a guarantee for the
acquisition of benefit streams from a specific
resource.

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This reduces costs since the property holder
does not need to physically protect what s/he
defines as hers/his
Instead the collective/the state, after having
acknowledged the exclusive right, protects it
by the law
This considerably reduces the cost of
protection borne by the individuals – their
transaction costs

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Firms might be efficient organizations
compared to markets
They economize better on transaction costs
It is cheaper to coordinate production within
the firm than via market transactions
Thus, the gradual establishment of the firm
and the differentiations into various types
may be seen as a response to high
transaction costs in societies experiencing
increasing division of labor.

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Within the efficiency perspective of institutions,
the existence of the state also is understood in
transaction costs terms
 It economizes on costs of enforcement
For example, state control of the quality of
money, for example, has evolved because it is
more efficient than other solutions
The gains in efficiency by creating a state appear
at two levels
First, the state is central to the very
establishment of the contract institutions since it
offers a third -party form of enforcement

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This is in itself an explanation based on efficiency
arguments
The trustworthy contract makes the gains from
trade possible
It is the state monopoly of coercion that creates this
ability
Second, the same monopoly force gives the state
a greater capacity to handle conflicts over
contracts than any other body
Hence, the existence of the state reduces
transaction costs at both the individual and
collective levels, and thus enables the full utilization
of the gains from specialization, a capacity
otherwise thought of as a gift of the market

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The role of the state in creating and securing
markets is important
However, it is also of importance for us to
acknowledge the potential role of the state in
creating institutional structures in situations
where markets are too costly to use, as is often
the case if we think about the allocation of
environmental goods
The cost of transforming these goods into
commodities may simply be too high
To demarcate air into sections so that it can be
traded is virtually impossible.

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The state can, however, be involved in
setting up regulations concerning the
use of air, such as emission taxes or
permits
It has the capacity both to make
decisions about what to do
concerning such common resource
dilemmas and to enforce the solution
–a capacity no market agent or
private organization has.
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ii) Institutional change induced by
technological change
When technology changes existing
institutions may not work well as before
According to efficiency theory, this
mechanism mainly comes about due to
changes in relative prices of input factors
that follow from technological change
Institutional change may be necessary to
restore equilibrium in input markets
The potential of the new technology may
not become available without some
changes in the institutional setting

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For example, the introduction of the
internet and mobile phones has required
new regulations and laws in the
telecommunication sector
The participation of the private sector
became intensified more than it was before
and new incentive mechanism became in
place to attract more investment in the
sector
Moreover, new operational guidelines
and regulations became in place in order
to protect consumers and the public at
large
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b) The Power (Distributive) Perspective
Scholars within this perspective do not accept demands
in efficiency as a cause of institutional change
Institutional change involve continuous bargaining
among actors.
Institutions emerge within conflicting situations, which
may not result in Pareto optimal conditions.
Rather, some actors may lose while others gain from
the process.
The losers are always those with lower bargaining
power.
However, potential losers may take measures to block
foreseeable change, as far as those measures are not
too costly to them

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On the contrary, it is equally likely that
actors expecting some gain from the
change will increase pressure towards its
implementation in order to realize their
goal.
Thus, it is the interplay of the powers of
different economic actors, which
determines the final direction of
institutional change.

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Thus, the main purpose of institutional
change is not to improve efficiency by
reducing transaction costs.
Efficiency improvement is rather a secondary
objective of institutional change
The major objective of institutional change
is to protect interests.
The efficiency perspective may not also
explain the emergence of firms
Many questions concerning power and
interest protection are implicated, too.

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First, the firm is a command structure; it is
organized in a hierarchical fashion as a way
to execute power.
Second, the firm is a means of securing not
only a higher total surplus, but also a
greater part of the surplus for owners.

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While the history of the firm is both one of
transaction costs reduction and one of power
enhancement, the same is the case with the
state.
Historically, and even in many countries today,
the state exhibits many predatory characteristics
as away of concentrating power and wealth in the
hands of a small elite
The state is not just a structure that has been
used to increase efficiency.
While its potential to reduce transaction costs is
huge, its role can certainly also be oppressive.

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The leaders may be more interested in
securing their own positions and wealth than
in creating institutions that benefit society
more at large.
Moreover, the definition about what is
efficient is not primarily a technical issue
about reducing transaction costs
Instead it is a question about which interests
and values we want to protect by using the
power of the state.

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In democratic systems the base of power is the
general public
Political power is granted by the public to political
agents, based on the policy agendas and envisioned
institutional changes that these agents propose
during election periods.
The public choice perspective, gives much attention
to the political dimensions of institutional change.
Theoretically, institutional choices are made directly
by voters or through their elected representatives.
Practically, however, political elites may not honor
their words

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The role of political ideology should not be
overlooked in state decision-making
With its ideological objectives, the state can enforce
new institutional arrangements whether the resulting
changes are economically desirable or not
When ideological motives dominate, state induced
institutional changes may take a revolutionary path to
bring about radical changes.
Indeed, many of the ideology-based interventions are
meant to address equity issues (e.g. state actions in
former socialist countries), but there is still no
guarantee that such interventions improve welfare.

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​Individual Assignment
1. Identify one institution
 Discuss the actions in the past 2 - 3 years in
order to reduce transaction costs and how
the change contributed to efficiency
improvements
 Discuss how in the past 2 - 3 years response
to technological change and discuss how
the change contributed to efficiency
improvements

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 2. Identify institutions from your experience
that justify the arguments of the power view.
 Who are the actors involved in the process
of institutional change?
 Whose interest counted at the end?

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