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Explanatory Power of the Induced

Institutional Innovation Theory


Lechuan Huang
Department of Economic History,
London School of Economics and Political Science,
London,
United Kingdom,
WC2A 2AE
l.huang1@lse.ac.uk
November 6, 2007

Abstract
As a pattern of thought, North, and other new institutionalist
economists use the theory of induced institutional innovation to ex-
plain the change and evolution of institutions. In other words, in-
stitutions should be developed in a way comparable to the forming
of equilibrium in economic markets. This essay uses a chain model
to analyse the explanatory power of this theory. The analysis distin-
guishes between institutional innovation and change. It finds that for
successful theoretical application to institutional change, favourable
preconditions, a shock that creates market disequilibrium, rational
agents that respond to the shock quickly, and a fairly competitive po-
litical market are required. However, for institutional innovation, the
theory is only relevant in that change is a necessary condition.

1 Introduction
It is intuitive to apply the market mechanism to the evolution of institutions,
for new institutionalist economists still base their theory on the, if somewhat
limited, interactions between rational agents.
The theory of induced institutional innovation (henceforth, the theory)
bases itself on that assumption. However, there is a danger, as North himself

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has realized, that the very market in question is a political one, which is not
as efficient as the economic market (see North, 1996, p.345). Hence, there is
no promise that institutional innovation will be induced as expected.
This article tries to gauge the explanatory power of the theory by building
a chain model. Through analysis of each link in the chain, the favourable
factors for the successful application of the theory can be identified.

2 The Model
Our model is a two-step one. Step one reduces institutional innovation to
institutional change. This is necessary because there are some nuances be-
tween the two, that is, qualitatively, institutional change involves less cost,
as it only requires efforts to switch to other known institutions.
Our major concern here is with the process that leads to institutional
change, be they borrowed or invented1 . Hence the second step–to fit institu-
tional changes into a natural framework where induction would be possible.
The theory uses the ‘market’ to describe this framework. In this article, this
market is broken into a chain of linked processes, and logically, the explana-
tory power of the theory will rest on the weakest link.

2.1 The Links


Figure 1 shows the links arranged in logical order. Details are explained in
following subsections.
preconditions Ô triggers Ô responses Ô interactions Ô change

Figure 1: The theory chain

2.1.1 Preconditions
The temptation to generalize should not prevent us from trying to identify
preconditions to expected institutional changes. This can be rephrased as
‘path dependence’, which states that the ‘direction’ of institutional change
is limited by former institutions and other conditions2 .
1
In analysis of institutional innovation, it is theoretically possible to add in some costs
of the inventive efforts (although practically it would be hard to quantify the costs.)
2
The new institutionalist economists’ emphasis on ‘property rights’ is in itself a mani-
festation that some institutions should come before others.

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2.1.2 Triggers
Triggers (or shocks) are factors that can disrupt the status quo and set off the
chain reaction. North and Thomas (North and Thomas, 1970) have offered
two major triggers for institutional change: variation in relative prices, and
expansion in the size of the market3 .

2.1.3 Rational Responses


That people will respond to economic changes is by no means self-evident.
It is especially true when we try to apply the theory to developing countries,
where the market mechanism is the very institution that we would like to
build. Various factors (culture, ideology, experience, etc.) can prevent people
from behaving rationally4 .
Even within a fully functioning market, there is still ample room for
irrational behaviours. Thaler (Thaler, 1996) have pointed out that people are
typically subject to bounded rationality, bounded self-interest, and bounded
will power, each is quite common in our daily life. Without perfect rationality,
how people perceive the economic triggers becomes a problem of concern in
our model.

2.1.4 Interactions
There is no warrant that changes in the economic sphere will bring their in-
fluence to the political arena. Democracy, especially in developing countries,
is a rare element. This is not to say, though, that any potentially beneficial
institutional change in a democratic country will be easy. The theory itself
says nothing about the elasticity of the demand and supply curves, which
can essentially turn our anticipation up-side-down.5
3
In summarizing the theory, Grabowski (Grabowski, 1988) adds in the changes of de-
cision rules of government as a third force for change, which, according to North and
Thomas, is a doubt factor that can reduce the explanatory power of the theory.
In this article, the two purely economical triggers are preferred, for North and Thomas
have argued implicitly that economic forces are the starting point, while political inter-
actions is the middle man. By adding political decisions as the third factor of change,
Grabowski has unwittingly changed the original argument.
4
It is possible, though, to treat the ‘market’ as a precondition, and shake off the re-
sulting irrationality problem.
5
Alston has suggested three categories of institutional change (Alston, 1996): system
driven (where no single agent has the power to impose change), demand-side driven,
and supply-side driven (where the demand- or supply-side respectively can impose new
institutions to capture the lion’s share from disequilibrium). Taking elasticity into account,
The three categories can be merged into a smooth curve of varying elasticity, with demand-
or supply-side driven situations as the two extremes, and the system driven case right in

3
2.2 The Hypothesis
The reason why the hypothesis comes after the model is that through model
building the hypothesis will emerge by itself. Indeed, even admitting the
limited applicability of his theory, North has not clearly stated any hypoth-
esis other than points to the root of neo-classical economics; that is, homo
economicus is the only hypothesis. Bates (Bates, 1995) is more severe in
suggesting politics as an alternative to the theory.
From the model we can see that, if the theory is to apply, the perceived
trigger must lead to economic disequilibrium. Any cases of forced institu-
tional change, through careful analysis, should not exist. We also need to
assume that the political market will work smoothly so as to work out a
formal institutional change, and that the transaction costs in the political
market will not be so high as to prevent economic benefits from being cap-
tured.

3 Analysis
3.1 The Cases of Thailand and Ghana
According to Feeny (Feeny, 1989), during the nineteenth century, with the
increase of international trade brought about by treaties, the rise of govern-
mental power, and the influence of Western colonialism, Thailand experi-
enced a relative rise in land price, which led to the abolition of corvée and
slavery; and a more elaborate institution of land property was developed.
However, as Grabowski (see Grabowski, 1988, p.390) points out, real
wages for labour rose dramatically between 1905 to 1935, immediately fol-
lowing the period discussed by Feeny. Yet the corvée and slavery institutions
did not come back.
Austin (Austin, 2007) analysed the effects of cocoa planting on the spread
of land property in Ghana. The initial shock was provided by the Second
Industrial Revolution, which created the market for rubber and cocoa. Me-
chanical transport facilitated the spread of cocoa planting. Therefore, the
original situation of relative land abundance shifted into a localized land
scarcity. Labour wages underwent changes, slavery was abolished by British
colonial rule; and land, which previously was almost a free good, became
controlled by property rights.
the middle.

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3.2 Applying the Model
The success of applying the induced institutional change theory to the Thai-
land and Ghana cases can be broken down into the successes of each link in
our model.
In both cases, the initial shocks were external (foreign treaties and the
Second Industrial Revolution), and they had directly influenced the economic
life of both countries.
It is difficult to examine if people indeed responded to economic changes
in these cases. In his analysis of Cocoa farming in Nigeria, Hopkins (Hopkins,
1978) shows that people can respond with various reason that can be totally
irrelevant to our discussion. In the case of Ghana, however, accessibility or
inaccessibility to the rail road did make a difference in distribution of cocoa
planting (Austin, 2007); therefore it is reasonable to assume that people
responded positively to shocks.
The interactions in the political market is also tricky, as abolition in both
cases came from the rulers. While it can be argued that political power only
accommodated the trend, there is always a possibility that they imposed the
new institutions at will. It is helpful to observe that on the informal level,
slavery did gradually fade out; so in the political market, the change is not
just a whim.
When we wish to limit our discussion to strict economic matters, the
failure to apply the theory in Thailand for the period between 1905 to 1935
illustrates the importance of preconditions. When corvée or slavery became
abolished, the global trend and social attitudes would not permit a restora-
tion.
However, there is another way to explain this failure if we take non-
economic factors into account from the beginning. Because land to labour
price ratio was not the only factor that contributed to the abolition of corvée
and slavery, the reverse of that ratio could not by itself restore the abolished.

3.3 Identify Key Determinants


From the above analysis we can try to extract some important determinants
of the explanatory power of the theory. If we restrict ourselves exclusively
to economic terms, successful application of the induced institutional change
theory requires favourable preconditions, a shock that creates market dise-
quilibrium, rational agents that respond to the shock quickly, and a fairly
competitive political market. For induced institution innovation, the ap-
plicability of the theory becomes precarious; who knows what could have
happened if George Washington had become the king, rather than the pres-

5
ident, of the United States?

4 Conclusion
By breaking the induced institutional innovation theory into a chain model
of precondition, trigger, rational responses, and political interactions, we are
able to analyse its explanatory power by examining each link. Any disruption
in the chain will reduce the applicability of the theory, e.g., unfavourable
cultural or global preconditions, shocks (such as foreign coercion) which do
not go through the market, irrational agents who simply ignore economic
opportunities, and relentless despots or monopolies.
Furthermore, to change into a set of institutions of a more advanced
country is not the same as creating a better yet unknown institution. Changes
can be induced, but the transcendence into innovation is above induction.
It is possible that the devising of the theory was Europe-oriented6 . Con-
temporary European history suffers much less from the aforementioned neg-
ative factors in the global context. Therefore, application of the theory to
countries outside the European economies needs careful and perhaps, ad hoc
observation.
To bring the discussion further, it might be helpful to take time frame
into account. Arguably, if given enough time, the benefit will be so large as
to remove any obstacle to institutional innovation.
Another worthy point will be that, it can be especially dangerous for
developing countries to seek institutional change, for it is easy for them to
copy, forgoing the opportunity to create a potentially more suitable set of
institutions on their own; and when the path is set, it is difficult to revert.

References
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6
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6
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