Notes on the Institutional Context

Institutional Change
- Week 8 Note -
Taco Reus

Week 8 Objectives
1. Understanding types, causes and consequences of institutional
change
2. Illustrating the different stages of institutional development
3. Considering accelerators and decelerators of institutional
development
4. Understanding concepts, such as path dependency, institutional
voids
5. Gaining insights in the institutional context of less developed,
transitional and emerging economies
6. Recognizing the institutional causes and consequences of major
worldwide changes

This week focuses on institutional change and development. Looking at the guiding
framework, you will see that apart from emphasizing the institutional spheres as
institutional drivers, history becomes an important force in shaping the institutional
context of nations. This influence of history is explained in large part by the principle of
path dependency on the one hand, and the role of critical historical events that sparked
change on the other hand. We will consider the forces that prevent and promote
institutional development or transition, and explain the institutional causes and
consequences of major change events.
Notes on the Institutional Context

Institutional change refers to shifts in the social constraints that structure political,
economic and social interactions. These shifts can occur gradually, when small institutions
are tweaked or slowly fine-tuned. Gradual change occurs within the broader boundaries
of an established institutional frame. Such institutional change is hard to observe because
it happens naturally in more incremental, longer-term patterns. In contrast, some
institutional change is more radical, and forces the broader institutional framework to
change. Radical institutional change brings the institutions to the forefront of attention.
The rules of the game become the focus point of political and public debate, and many
institutional players actively try to shape the alteration of established institutions or the
creation of new institutions. As a result, political, economic and social interactions are
more clearly affected by such changes and the consequences can be more readily
observed.

In this Note, we discuss specific forms of institutional change. We first pay specific
attention to institutional development, which involves a process in which less complex
systems of institutions turn into more complex systems. We pay attention to why certain
countries do develop, while others lack behind. This also leads us to discuss rapidly
emerging markets, and less developed markets. Subsequently, we consider several recent
institutional causes and consequences of major recent changes, such as the financial crisis,
environmental change, and change due to a natural disaster.
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 Institutional Development
Nobel Laureate, Douglas North1 provided an answer to a central question related to the
institutional development: “Why do some economies develop, while others lag behind?”
He described that countries tend to go through different stages of institutional
development from local autarky to a modern society:

i. Trade within the tribe/village

ii. Trade beyond the village
iii. Long distance trade
iv. Further expansion of trade
v. Modern trade

This is a process from autarky – i.e., a state of being self-sufficient – to increasing reliance
on specialization and division of labor, which makes trade increasingly complex and more
dependent on a wide range of institutions. This process also is reflected in increasing
levels of transaction costs. Transaction costs refer to the costs of participating in a market
- i.e.,

Notes on the Institutional Context

the costs in making an economic exchange. These costs relate to (a) search and
information costs (costs of searching for a good, determining which has the lowest price,
determining the quality, etc.), (b) bargaining costs (costs required to come to an
acceptable agreement with the other party in a transaction, costs of drawing a suitable
contract, etc.), and (c) monitoring and enforcement costs (costs of making sure the other
party holds itself to the terms of agreements, and taking suitable actions if they don’t).

The first stage – trade within the village – is characterized by extremely local exchange
with the village. These societies have also been referred to as tribal communities or
“hunting and gathering” societies, where the men hunted, while the women gathered.
This society functions like a local autarky – the family or the group takes care of itself for
all its needs, so there is minimal specialization. Small scale village trade exists among
relatives in a dense network (i.e. with tightly-knit relationships). In such a group, informal
rules facilitate local exchanges by determining the roles group members take, and the
ways in which work is done is informally agreed upon. This is possible because people live

1The description here of institutional development is taken from North (1991), with clarifications and
extensions to facilitate its comprehension.
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near each other and have an intimate understanding of each other. As a result of the
intimate knowledge people have of each other, there are no costs in transacting – there
are no information, bargaining and monitoring costs related to exchanges, though there
may be quite high social costs to a tribal organization (i.e., the costs endured by the group
or tribe as a whole). People stick to the family order, mainly preserved by the threat of
violence. There is no external State or even local government influence, and no formal
institutions at this stage of institutional development.

In the next stage – trade beyond the village – trade moves out of the village and into the
regional bazaars or regional markets. People now start to specialize – for example, in
potatoes, vegetables or cattle – and they not only produce for themselves but also for
exchange on the market. The size of the market extends exponentially, and exchange
parties have less intimate knowledge of each other, which increases the possibility of
conflict over what is being traded, and raises transaction costs sharply. People incur
transaction costs as they have to travel to the market and search for the best products
they are interested in, and costs are incurred in negotiations and determining the quality,
weight, size etc. Thus, while production costs go down through specialization, transaction
costs go up. This regional trade occurs without the oversight, monitoring and
enforcement of an external State. Instead, religious precepts determine the standards
and rule-compliance of the players. As a result, the effectiveness of the informal
institutions depends largely on the extent that these religious precepts are held to be
binding.

The third stage of institutional development is characterized by long-distance trade, for

example, by the so-called caravans or along the Silk Road or through shipping routes over

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the oceans. In this stage, some
economies of scales arise through
more geographic specialization in
specific regions where regional
products are produced, for example
in agricultural products, or silk in
China, carpets in Persia, pepper in
Southeast Asia. The period also
characterizes more occupational
specialization, for example in farming, trading, transporting. Long-distance trade brings
together buyers and sellers from distant regions in the world, and along the trading
routes temporary gathering places arise, as well as more permanent towns and cities.

However, in long-distance trade two transaction problems emerge: an agency problem

and a problem of contract negotiation and enforcement over long distance. The agency
problem refers to the potential for diverging interests between a “principal” – an owner
of goods that are traded – and an “agent” – a subordinate who performs activities for the
owner, such as the person charged to transport the goods over long distances. In
longdistance trade, owners generally would not transport their goods from one part of the
world to another part themselves. Instead, they used agents but these agents could have
different interests – for example, sell the goods to someone else and never come back to
the owner. Owners could resolve the agency problem by monitoring the activities of the
agent. Yet, this is difficult when the agent is traveling far away. Another way to resolve
the problem would be by aligning interests of the agent with that of the owner. As a
result, owners often relied on sending relatives, with whom they were more likely to
share the same interests, and for whom breaches of the agreement to transport the
goods would be more consequential – it could mean exclusion from or reprimands by the
family. The success of the trade then depended on the strength of family ties and the
price of defection (the price might be much higher for a favorite uncle rather than a
despised distant cousin). The agency problem increased as the size or the value of the
trade went up.

A second transaction problem that arises in long distance trade is a contract problem,
which stems from having to negotiate and enforce contracts over long distances where it
is not easy to achieve agreement and enforce contracts. This enforcement entails not only
the agreement to buy and sell but also the protection of the goods en route from pirates,
gangsters and thugs. Enforcement en route was met through the protection by armed
forces and by paying toll or protection money to local kings, princes and lords. To
facilitate negotiation and enforcement over long distances, there typically was a need to

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 Notes on the Institutional Context

develop standardized weights and measures, units of account, a medium of exchange,

notaries,

consuls, and merchant law courts. This complex set of institutions, organizations, and
instruments made transacting and engaging in long-distance trade possible by lowering
information costs and providing incentives for to stick to a contract. A mixture of informal
and semi-formal bodies (such as the old merchant groups) that effectively could exclude
members that didn't live up to agreements enabled long-distance trade to occur.

In the fourth stage of institutional development – urbanization – towns became more

important centers of exchange. Such institutional development allowed markets to
expand, producers to specialize more, and allowing greater economies of scale.
Moreover, it gave rise to more hierarchical producing organizations with full time workers
working with some specialist function. The process subsequently leads to a need for
effective, impersonal contract enforcement, because personal ties, informal constraints,
and threat of exclusion become less effective as more complex and impersonal forms of
exchange emerge. Clearly personal and informal agreements remain important even in
today's highly interdependent world. However, if effective impersonal contracting (i.e.
formal institutions) does not exist, too often the gains from "defection" are too good to
prevent the development of complex exchange.

More trade became possible with much more institutional development. For example,
the rise of capital markets (to direct wealth of savers to companies or governments who
can make large investments) required that property rights were secured over time, rather
than that political rulers haphazardly could seize assets or radically change their value.
Establishing a credible commitment to secure property rights over time could happen if a
ruler would restrain itself in using coercive force. However, that seldom has been
successful for very long, particularly when rulers got substantial debts (often because of
warfare or extravagancies). More successful was the process whereby property rights
could be secured if society could constrain the power of the ruler. This required
fundamental changes in political systems, such as the “Glorious Revolution” of 1688 in
England, which gave parliament supremacy over the crown.

Also, institutional development allowed manufacturing to advance more through

technology. The effective use of technology required large investments in factories and
machines, uninterrupted production, a disciplined workforce, and transportation
networks – i.e., technology required effective factor and product markets. Such markets
require secure property rights, which entail a political and judicial system that permits low
costs contracting, flexible laws permitting a wide range of organizational structures, and
the creation of complex governance structures to limit agency problems in hierarchical
organizations.

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 In the final stage of modern trade,
specialization is optimized. Now, everyone
has a specialized function, and relies on a
huge, worldwide network of interconnected
players that all provide goods and services.
At this stage, agriculture requires only a
small percentage of the labor force, and
markets have become nation-wide and
worldwide. This requires extremely
complex organizing and extensive
institutions. Nearly everyone takes a highly
specialized function to become part of an
extremely large network of buyers and
sellers across long
distances. International specialization and division of labor requires institutions and
organizations to safeguard property rights across international boundaries. There is
specialization in trade, banking, insurance, etc. In this form of trade, transaction costs
have become an extremely large portion of the total costs.

Impediments to Institutional Development – Less Developed Economies

While this staged development of trade from tribal hunting and gathering societies to
today’s modern societies seems to have occurred smoothly in some regions of the world,
there are still plenty of countries or regions that are in the earlier stages of institutional
development. So an important follow-up question that is addressed by historical
institutionalists like Douglas North is why institutions do not evolve. At each stage, there
tends to be forces that block the society to move to a next stage. In particular, societies
that are characterized by trade in the village and regional trade are unlikely to evolve from
within.

The earliest form of trade (in the village) relied on a dense network where people have
strong sense of loyalty toward the group and positions and roles are tightly guarded. In
these groups, deviance and innovations are viewed as a threat to group survival. As a
result, the village remains self-sufficient and distant excursions are avoided, limiting the
likelihood that the society moves to more regional dispersed trade.

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 Notes on the Institutional Context

The regional trade economies – such as the bazaar – also still are present today. On these
markets, an extremely large number of small transactions tend to occur, face-to-face,
which are more or less independent from each other, and goods and services are not

Notes on the Institutional Context

homogeneous (there often is a wide variety of characteristics and quality that are difficult
to measure). This regional market is characterized by a lack of institutions that help the
access and distribution of information – there are no price quotations, production reports,
employment agencies, consumer guides, etc. The systems of weights and measures are
incomplete at best and often can be manipulated. Under these conditions, exchange skills
determine who prospers and gains power, and who misses out. Bargaining and haggling
over prices and terms prevails. Trading involves continuous search for specific partners,
rather than simply offering goods to the general public. Regulation of disagreements
depends on reliable witnesses, not some legal codebook. Jurisdiction and government
control are purposefully marginalized and kept out.

In sum, regional trade is characterized by high measurement costs, specific but diverse
clientele, and intensive bargaining at the margins – the name of the game is to have more
information than the other party in the exchange. And since having information is so
important, in the absence of any formal rule system to reduce information asymmetry,
the dominant players have little incentive to change the rules – it is the very reason why
powerful players have become so powerful in the first place, and they have no incentive
to lose that position. Thus, tightly connected, powerful political and economic players
tend to profit from the existing institutional framework, and the parties who would have
the power to make changes do not have an interest to do this because they stand to lose
power and associated benefits from a change.

Path dependency of institutions provides another more general reason why countries are
constrained in their institutional development. This principle emphasizes that “history
matters” when it comes to the development of institutions. Decisions in the past
influence the rules of today and future possibilities. The span of possible changes in rules
depends on current shape of institutions, which is influenced by events in the past. It also
means that accidental choices may determine a path from which it is difficult to depart at
a later stage.

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Path dependency explains the development and persistence of institutions, whether they
are regulatory, normative or cognitive. Rules of the game once accepted often are
lockedin, and through positive feedback in the adoption of the rules, their use becomes
more widespread and the benefits of following the rules greater. So, much of the laws
that are in place in the United States can be traced to the Constitution, or the institutional
context in the Netherlands still reveals some of the protestant work ethic that was
promoted centuries ago.

The underlying mechanisms that explain the path dependence of institutions are that
institutions come with high “switching costs” – it is often very difficult, expensive and
timeconsuming to change the rules. Institutions generally determine the value of
strategies, habits, and routines parties follow or make. So, any switch will be costly for
most parties involved. Also, institutions come with high “sunk costs” – it may at times
take years or decades to align interests of different stakeholders that shape the
institutions. When agreement is reached and involved parties have invested so much
time and resources in forming the institution, people become committed because of the
sense they already have invested so much. When countries lack path dependence of a
particular institution, they can sometimes leapfrog into applying novel standards. For
example, when England reached the limits of industrialization, it had an institutional
context that served industrialization but made it difficult to adapt to post-industrial needs.
In contrast, those countries that had missed the industrial revolution could leapfrog into
building an institutional context that better fit post-industrial needs.

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 Notes on the Institutional Context

Base of the Pyramid

Today, by far most people still live in less developed markets or regions of the world.
An estimated 4 billion people live in so-called survival markets, where most people live
below annual incomes of $3,000 (US
2005, PPP – World Resources
Institute). Scholars have referred to
this as the Base of the Pyramid, and
have developed a so-called “business
case” to reduce poverty of the base.
It calls for Multinational Companies
(MNCs) to focus on the Base of the
Pyramid, to help create jobs, and
create new markets for affordable
products. But it also creates
opportunities for MNCs:

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 Notes on the Institutional Context

1. MNCs can improve profits by exploring new growth markets in the Base of the
Pyramid when home markets are saturated.
2. MNCs can considering aggregated demand (e.g., for internet and mobile phones),
which can be substantial – while there may be few people that can afford a mobile,
groups of individual may be able to afford it, and considering the Base is so large,
aggregated demand can provide lucrative opportunities.
3. MNCs can exploit low-cost strategies by for example by “outsourcing” activities to
the Base.
4. MNCs can boost innovation when it explores opportunities in the Base, because it
forces decision-makers to think more efficiently, less costly, and more sustainable.

There are many products and services that are much more expensive for people in less
developed markets than they are for people in more developed markets. For example,
interest on loans can be over 50 times more expensive in poor areas (and may at times be
up to a 1000% of what Westerners tend to pay!); water can be 37 times more expensive,
and phone calls can often be much more expensive as well. Often, products and services
also have a much lower quality. So, MNCs can serve the Base of the Pyramid by providing
products at a more affordable price and with better quality.

However, generally the Business Case is insufficient to forge institutional development.

Rather, institutional development depends on all institutional spheres.

The Quality of Institutions from the Perspective of the World Bank

So, countries vary widely in the extent of institutional development, and as institutions
develop, the context provides more opportunities for arm’s length transaction in which
buyers and sellers of a product act independently and have no relationship to each other.
The parties can act in their own self-interest and are not subject to any pressure or duress
from a third party. On a regular basis, the World Bank assesses indicators of governance
and institutional quality of countries. Considering the importance of credible commitment
by the State to individual property rights, this exercise broadly considers the set of
traditions and institutions by which authority in a country is exercised. The quality
assessment entails three areas that each is evaluated on two dimensions.

First, institutional quality depends on the process by which governments are selected,
monitored and replaced. This involves the extent to which people have a voice and
people’s representatives are held accountable. That is, this involves the extent to which
country’s citizens are able to participate in selecting their government, as well as freedom
of expression, freedom of association, and a free media. This institutional quality also

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 Notes on the Institutional Context

involves political stability – the likelihood that the government will be destabilized
because of vulnerability or economic distress, or overthrown by unconstitutional or violent
means, including domestic violence and terrorism.

Second, the World Bank assesses the capacity of the government to effectively formulate
and implement sound policies. On the one hand, this capacity depends on government
effectiveness, which involves a reliable public service, a strong civil service that is
independent from political pressures, and credible commitment of the government to
such policies. On the other hand, this capacity depends on regulatory quality, which
refers to the ability of the government to formulate and implement sound policies and
regulations that permit and promote private sector development. For example, countries
vary in the extent to which they monitor and avoid unfair competitive practices, or how
easy or difficult it is for start-ups to comply with administrative formalities.

Third, institutional quality depends on the respect of citizens and the state for the
institutions that govern economic and social interactions among them. For this dimension,
the World Bank considers rule of law – that is, the extent to which citizens have
confidence in and abide by the rules of society. This is particularly about the extent to
which contracts can be enforced (people have to stick to the agreement they made with
each other). So, this also entails the strength of the police and the courts, as well as the
likelihood of crime and violence in a country. In addition, the World Bank consider control
of corruption, or the extent to which public power is not used for private gain, including
petty and grand forms of corruption.

It is important to note that the assessment by the World Bank has been criticized. In
particular, critics argued that “quality” here is determined from a Western point of view
that is characterized by a focus on individual voice. Also, some countries with a somewhat
lower regulatory quality (e.g. Japan) have been successful, and weak formal institutions
are not necessarily harmful. When formal institutions are weak, there often can be a
system of informal institutions in place that fulfils important needs to foster economic
exchanges.

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 Notes on the Institutional Context

Emerging Markets
Emerging markets are countries that are rapidly growing economically and industrially,
boosting trade and investment liberalization, and taking a central role in world markets.
While growth rates tend to be much more volatile, they tend to be much higher than the
growth rates of developed economies. The so-called BRIC countries (Brazil, Russia, India
and China) are most often included on the list of emerging markets. However, there are
quite a number of other countries that fit the description. The term “emerging market”
may not anymore capture the state of many of the economies. In particular, the size and
growth of the Chinese market has been so tremendous that a more appropriate label
would be “newly arrived markets” or “top growth markets.”

Emerging markets are home to a large portion of the world population, and the rapid
growth has its impact on the citizens with rising income levels and an expanding middle
class that can afford more luxurious goods. Demand for natural resources (e.g., oil) and
food also increases rapidly, which can often be very difficult to fulfill.

The high economic growth, large populations, and lower cost labor that characterize
emerging markets are attractive to MNCs. However, MNCs tend to perform much worse in
emerging markets than they do in their home markets. An important reason for this is that
emerging markets cannot really be treated as one type of market – there are many
differences among the emerging markets, and these are often difficult to identify through
general country analyses. Emerging markets provide important but extremely difficult
expansion possibilities for MNCs.

Tarun Khanna and his colleagues (e.g., in Strategies that Fit Emerging Markets) illustrate
some of the mishaps firms make when attempting to expand into emerging markets. For
example, often the choice to enter emerging markets is not made on the basis of thorough
analysis. The choice can often be viewed as herding or mimetic isomorphism, where firms
mimic the entry decisions of competitors, or follow key customers. Moreover,
decisionmakers who are embedded in a home institutional context may hold a biased view
of these emerging markets.

To make more informed expansion decisions, executives often conduct country portfolio
analyses, political risk assessments, economic analyses, by comparing GDP per capita,

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 Notes on the Institutional Context

population composition and growth, exchange rates, PPP, and the Global Competitiveness
Index. In addition, the institutional quality from the World Bank may be compared.

Decision-makers derive
make their conclusions
on the basis of
“composites” – i.e.,
aggregated data that
combines information on
a large number of items.
Khanna and his
colleagues
(in 2005 – Strategies that
Fit Emerging Markets)
illustrated that when
information is combined
into a single number it
may seem that emerging markets hardly differ. For example, when considering
country risk scores in 2005, BRIC countries hardly differed (composite scores were all

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 Notes on the Institutional Context

between 70 and 78). And when combining a series of composites the difference may
be marginal. Yet, these composites often conceal underlying differences that make
each emerging market unique. The emerging markets generally vary widely in the
institutional context, and require very different strategies from the MNCs.

Khanna and his colleagues coined the term institutional voids to refer to the absence of
institutions that facilitate exchanges between buyers and sellers. Often this entails a lack of
specialized intermediary firms, such as market research companies, logistics providers, or
recruitment companies that are omnipresent in more developed markets. In addition,
institutional voids can reflect a lack of regulatory systems on which MNEs depend in most
of the markets they are active in. For example, contract enforcement mechanisms may not
be in place or rely much more on informal ties, and legal systems may be slow or weak.

In order to be successful, rather than looking at the composite indices, executives should
take a more idiosyncratic approach to entry and expansion strategies into emerging
markets by examining the institutional voids that characterize the markets, and that they
will likely encounter when doing business in emerging markets.

As emerging markets call for more idiosyncratic analyses, it requires also asking
finergrained questions about the roles and power of the institutional spheres in each
country. The influence of the State may vary and it is often important to ask to whom the
country’s politicians are held accountable, whether the courts, administration and
politicians are independent, or to what extent national or regional political influences may
be important. In this regard, involvement of politicians in business may constitute an
institutional void because that involvement complicates the interactions between buyers
and sellers. The power and role of Civil Society may also differ among emerging markets.
Religious, regional, linguistic and ethnic groups vary, as well as the presence independence
of the media, NGOs, civil rights groups, environmental groups, and the extent to which
family ties are important.

The Market also may reveal institutional voids in three ways. First, institutional voids may
be related to expectations and information about consumers and suppliers of product
markets. There may be limited access to reliable information or consumer reports, and
consumers may not have a voice or limited product expectations. Regarding suppliers,
MNCs may lack the ties with important networks, or may not understand who controls
such a network. Infrastructure and transport logistics may be weak in a country. More
generally, product-related environment and safety rules that are widely accepted in more
developed markets may not be in place in emerging markets.

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 Notes on the Institutional Context

Second, labor markets of emerging markets tend to have institutional voids. Emerging
markets have large populations but it is often difficult to find good people. And often
there are substantial differences in cultures and in managerial approach. Educational
systems vary considerably across emerging markets, and in some markets technical and
managerial education may be lacking. Seniority may play an important role in
organizational hierarchies, which may constrain the careers younger colleagues can make.
Moreover, labor contract enforcement can sometimes be weak, and there may be more or
less tolerance toward foreign managers. At the same time, there may be institutional
voids related to labor rights and child labor.

Third, emerging markets have capital markets that are still developing, and the countries
vary in the extent to which these are characterized by institutional voids. For example, the
effectiveness of banks and insurance companies may vary considerably. Often, there is a
lack of credit rating agencies or analysts that are common in more developed markets. As
a result, it may be more difficult to determine whether suppliers or consumers have
sufficient funds. It makes it difficult to assess the corporate governance – i.e., the system
of structures, rights, duties, and obligations by which firms are directed and controlled.
When there are no clear expectations regarding corporate governance, it becomes
difficult to trust local partners.

Equity markets in many emerging markets are not yet fully or reliably in place. However,
China continues to focus on building a partnership between Hong Kong and Shanghai to
forge a new financial center – Shangkong. Some analysts even believe that following the
financial crisis, there will be a shift in the financial gravity of the world toward Shangkong.
China now owns some of the largest banks in the world, and has been attracting some of
the best financiers in the world.

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 Notes on the Institutional Context

So, emerging markets can vary considerably in the institutional voids related to the three
institutional spheres. In addition, emerging markets vary considerably in the extent to

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Notes on the Institutional Context

which the institutional spheres are open to foreign activity. Emerging markets vary in the
extent to which the governments, media, people in the country are open for foreign
investment, foreign people, or foreign ideas? Lack of openness can create considerable
trade, social, and administrative barriers. Interestingly, “openness” often has a different
meaning in different markets. For example, Khanna and colleagues found that China is
very open to foreign direct investments, but has long prevented citizens to travel abroad
and still is less open for Western ideas (consider for example, Google’s troubles in China).
In contrast, India is relatively closed for foreign direct investment in specific sectors but
much more open for Western ideas, and Indian people have long been able to travel
freely around the world. As a result, in India, many managers have a more western
orientation.

As institutional voids make entering less developed and emerging markets so difficult for
MNCs, success often depends on being able to fill institutional voids. Resource rich MNCs
often have the opportunity to do this – for example by investing in local infrastructure, or
educational projects to develop essential local expertise. For example, Unilever has been
very successful in India through its subsidiary Hindustan Lever by being able to find an
innovative approach to penetrate distant rural communities where two-thirds of India’s
population lives in very small communities. The approach is called Shakti, which means
empowerment. Shakti involved building and supporting a network of female
entrepreneurs in small villages, and giving men from the Shakti households a bicycle to be
able to cover a cluster of villages in the neighborhood. Currently, there are over 30,000 so-
called
Shaktimaans across India, which allows Hindustan
Lever to reach a market even though its characterized
by considerable institutional voids.

Recent Institutional Change

The causes for radical institutional change may come suddenly; for example, when a
natural disaster hits a region, it may trigger a reconsideration of the institutional
framework to prevent or limit the effects of future disasters. Sometimes the causes for
radical institutional change evolve more slowly when their effects remain ambiguous or
largely unnoticed for a considerable time. Only when effects become more visible or
when multiple smaller effects come together to create more precarious conditions, will

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 Notes on the Institutional Context

radical institutional change enfold. This latter form of radical institutional change has
been, and still is the focus of public debates on the financial crisis and climate change.
Both have long roots but have reached a vital stage only recently, which now presses the
institutional players to reconsider the institutional frameworks.

The remainder of this Note places the topic of institutional change in recent events. We
first consider institutional causes and effects of the financial crisis and climate change, and
then discuss institutional consequences of a natural disaster in Japan.

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 Notes on the Institutional Context

Institutional Causes and Effects of the Financial Crisis

The financial crisis and subsequent European
Sovereign Debt crisis have been at the center of
attention over the recent years. Just to give a
quick recap of what happened, let’s consider some
figures. To understand the shockwaves that run
through the markets, we can consider the earnings
of Standard & Poor’s 500. This aggregate is made
up of the 500 strongest companies in the United
States. The index is considered the “bellwether”
(i.e., leading indicator of future trends) of the US
and world economy. Figure 1 shows the

performance of this index since 1935 when S&P started the index. The index steadily
increased over the decades, and never saw negative earnings in the 20th century. But that
changed in 2008 following the financial crisis, with a severe impact on the S&P 500.

This trend also reflects the sharp decline in Global GDP in both the developed world and
less developed or emerging economies. The Financial Times started providing European
Economic Forecasts, which also depicted sudden dark clouds that overshadowed many
European countries (Figure 2).

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 Notes on the Institutional Context

As you can see in Figure 3, operating

earnings of the S&P 500 went back
up again. However, the financial
crisis has turned into an economic
crisis, sovereign debt crises of
countries, and has subsequently
turned into a crisis of governments
among numerous countries. Iceland,
Greece, Spain and Portugal are
notable examples. But many other
countries are affected as well,
because they have carried the brunt
of the crisis and had to take on considerable debt.

Institutional Causes of the Financial Crisis

As the financial crisis unfolded, much discussion focused on what its institutional roots
could be. Some have argued that “boom-bust” processes happen because of a “culture of
credit” or regulations that facilitated taking on increasingly more credit. It leads to a
process where easy credit generated demand, which raised the house prices, which raised
the credit again.
Financial markets stimulated consumers to borrow on increasingly more “attractive”
terms. The bubble started when people bought houses with the expectation that the
mortgage could be renewed with a profit.

A second institutional cause may have been an increasingly lax regulation by the state
since the 1980s. In the 1980s, U.S. president Ronald Reagan and U.K. prime-minister
Margaret Thatcher both pushed for a more deregulated market. They argued that market
mechanisms could best regulate the market themselves. According to this liberal view on
regulation, State intervention would only create barriers to efficient market interactions.

However, the increasingly lax regulation allowed for flawed competition and excessive
market conditions.

A third institutional cause may have been the gradual shift in banking from a focus on
social relations with clients toward increasingly distant relationships and emphases on
highly complex products, such as subprime mortgage products. These complex products
were generated by the so-called “quants” (data specialists with a background in
mathematics or physics), who traded their academic labs for financial laboratories for very
attractive salaries and employment packages at the banks and insurance companies.
These products became so complex that government regulators could not determine their

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 Notes on the Institutional Context

risks. As a result, the regulators became dependent on the risk analyses of the quants
themselves. Even the “rating agencies” (Moody’s, S&P, Fitch), who took the role of
independent commercial assessors of some of these complex products may have become
too dependent on information from the product inventors.

A fourth institutional cause may have been a culture of “indecent bonuses.” Throughout
the decades it became the norm to have relatively stable wages but quick bonuses. Often,
the underlying rationale for these remuneration packages was to stimulate “talent.”
However, they may have stimulated a focus on more short-term profits at the expense of
long-term gains.

It is important to note that there is no single institutional player responsible for the
financial crisis. Rather, all institutional spheres (state, market and civil society) influenced
each other to create the “perfect storm” that eventually led to the crisis. Much of the
institutional causes remained ambiguous or were (sub)consciously disregarded because
the institutional players themselves benefitted too much from the weaknesses of the
institutional framework. Of course, in the end the institutional framework proved
unsustainable, and the crisis unfolded.

Institutional Effects of the Financial Crisis

It is still early to determine the institutional effects of the financial crisis. There has been
much political and public debate on the topic. On the one hand, the effects will be most
notable on changing regulatory systems. On the other hand, some analysts argue that it
pushed to change the landscape even more drastically, where recently emerging markets
take on a different, more important role in shaping new institutions or reshaping
established ones.

Many countries are currently debating how the regulations need to change in order to get
out of the crisis, and prevent future ones. In the United States, the senate held numerous
hearings on the topic and President Obama is initiating stricter regulations on Wall Street.

In many countries around the world similar debates are held. Leaders stress that
countries avoid making protectionist moves in response to the crisis. However, in periods
of decline, national interests often become more important, particularly as economic risk
becomes a political, social, environmental and security risk.

There is a regulatory focus on making the financial markets more transparent and
trustworthy. An important difficulty in establishing this new design of institutions is that it
requires global coordination. Banks, and companies in general, may take activities
elsewhere if regulations are too hard to comply to. Economist Joseph Stiglitz warns that if
the regulations differ across countries (or states) there is a real risk of regulatory
arbitrage. This refers to the movement of company activities to the weakest regulated

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 Notes on the Institutional Context

jurisdiction. So, if there is no strong and clear global coordination, regulatory arbitrage
might hinder ample institutional change.

On the other hand, the global slowdown may change the institutional landscape where
different players become more powerful. Some authors (e.g., Raman in a compelling 2009
HBR article “The New Frontiers”) argue that emerging markets may come out on top
following the economic downturn. While the United States has long set the tone for
market rules and principles, some critics now argue that the financial crisis had its
institutional roots in the United States. Consequently, some governments are now less
inclined to look toward the United States as rule maker to direct the institutional change.
You can see this effect also at top meetings such as the G20 Summit, where other players
have become more vocal, and the U.S. hegemony position is no longer taken for granted.

The emerging markets become increasingly important and might play a more important
role in the post-crisis landscape. Raman stresses that the emerging markets have
discovered each other as important trade partners. Over the last two decades the exports
and imports between emerging markets have doubled in size, and in 2007 accounted for
40% of their total trade. So you can see different countries strengthening ties around the
world and reshaping the economic as well as institutional landscape.

This is also reflected in the political contests for important jobs at the supranational
organizations. During the Bretton Woods meeting in 1944, the U.S.-Europe power was
apparent by the decree that the International Monetary Fund (IMF) would always have a
European head, while the World Bank head would be appointed by the U.S. president. So,
when, in 2011, Strauss-Kahn had to step down as chief of the IMF because of an alleged
scandal, Angela Merkel and several others stressed her support for the French minister of
Economics and Finance, Christine Lagarde, and she eventually got the job. However, the
tradition of having European chiefs of the IMF faced strong pressure from the emerging
markets of Brazil and China. Similarly, the World Bank, which traditionally has been
headed by a U.S. citizen, saw a changing of the guard in 2012. While again there was a lot
of pressure from the emerging markets to change the tradition, Obama did appoint an
American, albeit a Korean-American – Jim Yong Kim.

Some emerging markets that are “unfriendly” toward the U.S. are greatly affected by the
crisis because they depend both on the strength of the dollar and the price of oil (Russia,
Iran and Venezuela particularly). If the U.S. can use their remaining economic and
institutional power to the benefit of the world instead of solely national interests, the
country could retain or even strengthen its position. Particularly, this is the case because
other nations or regions (such as China, India or Europe) are unlikely to be able to take
over the U.S. hegemony position easily.

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A more optimistic perspective on the institutional effects of the financial crisis is that it
may encourage the development of new and smarter regulations, and provide
opportunities for new and smarter companies and people. It is becoming increasingly
clear that a post-crisis era will be one that is driven by highly sustainable sustainability –
i.e., not simply sustainable in competitive advantage, but environmentally sustainable
competitive advantage. People and companies are increasingly redesigning their skills to
be able to capitalize on the low-carbon and clean energy economy of the future.

Institutional Causes and Effects of Climate Change

This second section of the note briefly discusses the institutional causes and effects of
Climate Change. An extensive report is beyond the scope of this course, though I do hope
that it triggers your interest in the topic.

On the one hand, climate change has natural causes. These are causes that cannot be
directly attributed to human actions. Instead, scientists point to the role of “continental
drift,” eruptions of volcanoes, a tilting earth, or specific ocean currents.

On the other hand, institutional causes of climate change that are human made. These
are difficult to summarize quickly because the roots are complex and ambiguous. To
make a (quick and dirty) attempt at identifying the institutional causes of climate change
we can first point to the Industrial Revolution. This era resulted in a large-scale use of
fossil fuels for industrial activities. Throughout the century, use of fossil fuels soared. This
trend increased the burden on natural resources, while vegetation increasingly had to
make way for construction, industries, transport and consumption. Concurrently, the
population increased substantially. Greenhouse gases flooded the atmosphere, leading to
what we now call the “Warming Planet.”

Institutional Effects of Climate Change

The difficulty to change institutions as a result of climate change is that fossil fuels, such as
oil, coal and natural gas, have long been the engine of many industries. Indeed, we are
“addicted to oil!” Fossil fuels provide most of the energy needed to run cars, and
generate electricity for industries and households. With such reliance it becomes difficult
to let go.

However, we do see that there has been a turning point that has made the topic of
climate change much more mainstream, and become a key point on the political and
public agenda.

Like the institutional change following the financial crisis, the institutional change to
curtail climate change requires global coordination. This is because in order to have a

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level playing field all markets have to set the same standards and regulations. Climate
Tops bring together many leaders from around the world. It often turns out to be too
difficult to agree on clear standards and objectives, though the urgency is increasingly felt,
and it is gaining political and popular clout.

Many companies are already experiencing the effects on their businesses. A so-called
Carbon Market has emerged in the European Union that allows firms to buy and sell
greenhouse gas emission credits. You can see similar markets emerge regionally in the
United States. In order to make these markets fairer, it is important that supranational
institutions are created that cover all trading partners.

For companies, it becomes increasingly important to consider their competitive position in

a market that is increasingly experiencing institutional changes in response to climate
change. Lash & Wellington (2009) emphasize four steps to improve a firm’s climate
competitiveness. The authors emphasize that before anything it’s important that firms
quantify their carbon footprint. A carbon footprint refers to the total set of greenhouse
gas (GHG) emissions that are caused by an organization, event or product. This is
particularly important because it is hard to do anything for a company if it does not know
what it is doing. Setting goals would be meaningless if firms do not assess their impact. A
second step is that firms assess their carbon-related risks and opportunities. Risks could
be regulatory, for example when regulatory policy may increase energy costs.
Opportunities could be that the clean energy market is big and growing – there is a large
portion of the population ready to buy cleaner products. A third step to attain a
competitive climate position is to adapt the firm in response to the risks and
opportunities. It’s one thing to assess the situation; it’s another to turn the conclusions
into action. Increasingly the largest companies that make significant research and
development (R&D) investments are able to adapt. For smaller and mediumsized
companies this adaptation is more difficult because of limited R&D, and because of
difficulties in hiring new employees to facilitate this adaptation. Finally, the fourth step
for

a company is to do it better than competitors. In many industries, firms can increasingly

gain market share not simply by being the low-cost leader or the most unique
differentiator, but also by gaining a reputation in climate control.

In conclusion, climate change, like the financial crisis, will affect the rules of the game. It
will affect how firms behave, how firms organize, how firms transact, and how firms can
attain a sustainable advantage (or a so-called “sustainable sustainable competitive
advantage”). It’s therefore extremely important to keep a close look at how climate
change is changing the institutions.

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 Notes on the Institutional Context

Institutional Consequences of Japan Natural Disaster

In the afternoon of Friday March 11, 2011,
an earthquake with a magnitude of 9 (Mw)
erupted just off the coast of Japan. It was
the most powerful earthquake that ever hit
Japan. The earthquake was followed by a
tsunami in the sea that struck the Japanese
coast shortly thereafter. At some places the
tsunami got as far as 10 kilometers inland
and devastated life and infrastructure on the
north-eastern Japanese coast line.
Subsequently, the tsunami caused several
nuclear disasters at the Fukushima Power
Plants. The economic costs of the Triple Disaster will likely exceed $300 billion making it
the most expensive disaster on record.

The police confirmed over 18,000 deaths. Prime Minister Kan at the time described the
events as the toughest and most difficult crisis for Japan since WWII. The sudden, radical
change in a country’s social and structural infrastructure impacts local communities in the
first place and had a major impact on businesses worldwide.

There were direct consequences on business. Some Japanese companies were prepared
because Japan has a long history with earthquakes and quickly relocated plants. There
were severe electricity outages in much of the northeastern part of Japan. Canon was
forced to halt production at several of its manufacturing plants. Effects were felt across
the world with shortages and delays in supply chains. Dutch-based Nedcar had to
suspend production because parts could not arrive from Japan. Imports at some ports
around the world saw contaminated food and products, such as contaminated beans in
Taiwan.

Power plants in Fukushima automatically shut down following the earthquake. Looking
back, experts indicated that Fukushima was not the worst nuclear accident ever, but it
became the most complicated. When the
nuclear power plants were affected by the
tsunami, cooling systems did not work
properly, and backup power systems were
also destroyed, which led to three large
explosions and radioactive leakage. The
Japanese Nuclear and Industrial Safety
Agency reported radiation levels were up to
1,000 times normal levels inside the plant.

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 Notes on the Institutional Context

Japan declared a state of emergency, resulting in the evacuation of more than 200,000
nearby residents. Because of the radiation farmers lost their crops, and demanded to
be compensated by the Tokyo Electric Power Company (Tepco). Analysts estimated 8.5
billion euro of payments. The total costs of the tragedy at the Fukushima nuclear plant
were estimated to be $105 billion, twice as much as Japanese authorities predicted at
the end of 2011. On May 20 2011, the chief of the company resigned after reporting
initial losses of 15 billion euro. In a public statement he apologized from “the bottom of
my heart” for the accident and bowed. Prime Minister Kan resigned a few months later.

While this was clearly a natural disaster, some critics have argued that there are
institutional causes that affected the ensuing nuclear crisis. The Japanese government
acknowledged that it did not protect Fukushima well enough for possible earthquakes and
tsunami. While the government and Tepco had initially stated that the earthquake was
“above expectation,” a study found that the plant and government had underestimated
many potential dangers in recent years. The study indicated that there was a chance of
10% that a tsunami would devastate the security at Fukushima. However, safety
regulations were not able to force Tepco to change the security situation, nor were there
appropriate means to enforce the rules and monitor compliance. Even a few weeks prior
to the earthquake, Tepco ignored security checks repeatedly, according to a report by the
Japanese nuclear security agency that was published 9 days prior to the disaster.

The nuclear crisis also has institutional consequences. The nuclear energy industry is one
of the most tightly regulated industries. There is widespread agreement that the industry
needs to be as safe as can be. Therefore, there are national and international safety
agencies to oversee the industry. Japan’s nuclear disaster triggered another round of rule
setting around the world. In Japan, a direct consequence was more direct government
control. The Japanese Government took control over Tepco (though it took less than 50%
of the shares because it did not want to nationalize the company).

An important role is being played by social movements. Social movements are a form of
group action - informal groups of individuals or organizations focused on particular
political or social issues. The intention of social groups is to carry out, resist or undo a
social change.
They focus on core institutional logics by bolstering a particular public stance on an issue.
As such they mainly aim to influence cognitive institutions, but they also try to influence
normative and regulative institutions. Consequently, social movements are important
because they challenge existing practices and advocate alternative ones. They can disrupt
institutional arrangements in markets, and influence entrepreneurial activity by
promoting new assumptions, norms, values and regulations that create new
opportunities.

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 Notes on the Institutional Context

There had long been a pro stance toward nuclear energy in Japan. In resource-poor
Japan, this pro stance can be explained by the desire of Japan to lower its dependence on
oil. Japan's power program consisted of more than 50 nuclear power plants generating
about
30% of the country's electricity. Before the disaster the plan was to increase that to 50%
by 2030. The government often stressed that technology can make nuclear energy most
efficient and safe. Shortly after the disaster Prime Minister Kan emphasized that the
damaged plants will be replaced by the safest plants that can withstand any kind of
disaster, using the most modern technologies. While the government reaffirms its nuclear
energy plans, public opinion is severely damaged. Anti-nuclear movements gained
traction as the nuclear crisis became more severe. The movement was small and ignored
by the general public before because many of the people that live near nuclear plants
were heavily subsidized, and received substantial donations from the government and
companies. These funds provided new schools, sports facilities, roads etc. However, the
nuclear crisis has slashed public faith in nuclear power and one year after the crisis all 50
reactors in Japan were taken off-line – for the first time since 1970, leading to power
shortages in the subsequent hot weather months. There were plans for reactivation but
they were met with little public support.

Across the world you can identify wide-ranging institutional consequences as well. The
European Union firmly stated it wanted to have the highest security norms for nuclear
energy. However, among the EU partners there was wide variation in the approach.
France, which has been even more pro than Japan toward nuclear energy (its plants
generate 70% of the country’s energy) remains very much committed to a nuclear plan.
The French government has stated that it wants to close “bad” plants – and implement
stress tests with direct consequences. The nuclear energy industry in France seemed to
be happy with good stress tests because it would help enhance their image, not only
domestically but abroad as well.

In Germany, where anti-nuke sentiment is much stronger there was a starkly different
effect. Angela Merkel quickly suspended plans to keep 17 aging plants for nuclear energy
open. In the months following Japan’s nuclear disaster more than three quarters of the
Germany’s nuclear plants were put offline because of maintenance or shutdowns ordered
by the government. Angela Merkel backed a plan to exit nuclear energy all together
within a decade. This opinion is gaining momentum in other countries as well. As an
alternative, this stance is accelerating the institutional shift to promote renewable energy
and solar power.

Pro-nuclear movements (e.g. Nuclear Green) argue that the media overemphasizes the
dangers of nuclear energy industry, and that coal, gas and oil industries may be even more
dangerous and also lead to toxic waste that affects the environment. They also emphasize
that technology makes nuclear energy the safest. Joseph Oehmen, MIT professor, has

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 Notes on the Institutional Context

become a figure head of the pro-nuke movement. He wrote an extensive email to a

cousin in Japan that described the risks following the nuclear crisis, which was posted on-
line and quickly went viral.

Normal Accidents Theory

Considering the nuclear power crisis that followed the tsunami we can also consider
Charles Perrow’s “normal accident theory.” Normal accidents are seemingly extremely
rare, but are in fact “normal.” They are accidents that cause multiple failures with
unforeseen interactions that accelerate into devastating consequences, while making
them harder to diagnose. The theory argues that “complexity” of the nuclear power plant
system, and socalled “tight coupling,” places such a demand on human responses that
accidents cannot be prevented effectively. Complexity is the degree of predictability in a
system’s processes. Complexity ranges from simple, when processes are linear, following
orderly step-by-step interactions with adjacent components to complex, when there are
many connections and interrelationships between components. Coupling refers to the
degree of connectedness in technological systems, i.e. the extent to which failures
escalate rapidly and spread to other parts of the system (or other technological
subsystems). Loose coupling allows for slack or buffering between the components.
Tight coupling results in direct and immediate connections and interactions between the
components. Nuclear power plants are technological systems that are highly complex and
are characterized by tight coupling among systems.

Perrow explained that when technological systems are so complex and tightly coupled,
accidents are bound to happen – they in essence become “normal.” These accidents may
not happen frequently, but these characteristics make a technological system inherently
vulnerable to such accidents. Japan’s nuclear crisis was initiated by the tsunami but the
tight coupling and complexity of the technological system also make contributions to the
severity of the consequences. This theory suggests that while often decision-makers or
operators are blamed for accidents, they are caused by errors that are designed into the
system. For example, safety systems are not always working (some may be down, and
known to be, some are accidentally turned off, some are not set properly, others fail to
work when needed). The safety reports prior to the tsunami suggest this was also the
case at Fukushima.

A sudden environmental jolt also has several consequences for following the rules. Tight
coupling tends to increase the likelihood that operators and employees follow strict rules
or informal routines that actually become obsolete or even harmful following a severe
environmental jolt. Moreover, directly following an environmental jolt decision-makers
are faced with this complexity and tight coupling, which could make it impossible to
determine the right decision. There are often no direct indicators of what is happening –
operators figure out what is going on only indirectly. There may simply not be a right

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 Notes on the Institutional Context

decision. At the same time, human nature calls for action. In the midst of making sense
of a complex and ambiguous situation, decision-makers therefore often somewhat
randomly will make a decisive choice. And, even though the initial decision may have
been more or less random, it quickly becomes the standard from which all subsequent
decisions are made.

Interesting Sources for Week 8

As mentioned in the text, the World Bank assesses the quality of institutions of a wide
range of countries. They do this every year for a total of 215 economies, and make all
data available in interesting graphs and tables, as well as raw data. You can find explore
their finding on their website: www.govindicators.org/

Another interesting source to consider institutional and economic information over time is
provided by Gapminder. This site uses data of other sources and provides tools to present
them in insightful ways: http://www.gapminder.org/

Background Readings
The stage model described in this note comes from Nobel Laureate Douglas North. He
wrote a book called Institutions, Institutional Change and Economic Performance (1990
Cambridge University Press) where he describes the different stages and how countries
were influenced by historical events that took them into very different paths. An article
that was published a year later presents a very good summary of the book. North DC.
1991. Institutions. Journal of Economic Perspectives 5(1): 97-112.

CK Prahalad has been very influential in developing ideas about the importance of the
bottom of the pyramid. His book Fortune at the bottom of the pyramid: Eradicating
poverty through profits provides an interesting view. An article that he wrote with Stuart
Hart presents a nice summary, which you can find online.
www.cs.berkeley.edu/~brewer/ict4b/Fortune-BoP.pdf

Khanna and his colleagues present their ideas about institutional voids in this article:
Khanna T, Palepu KG, Sinha J. 2005. Strategies that fit emerging markets. Harvard Business
Review 83(6): 63-76.

Greenwood R, Hinings CR. 1996. Understanding radical organizational change: Bringing

together the old and the new institutionalism. Academy of Management Review 21(4):
1022-1054.

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 Notes on the Institutional Context

Seo M-G, Creed WED. 2002. Institutional contradictions, praxis, and institutional change: A
dialectical perspective. Academy of Management Review 27(2): 222-247.

Zietsma C, Lawrence TB. 2010. Institutional work in the transformation of an

organizational field: The interplay between boundary work and practice work.
Administrative Science Quarterly 55: 189-221.

Understanding the roots of the financial crisis

An insightful clarification on the root causes of the financial crisis can be found here:
https://www.youtube.com/watch?v=mzJmTCYmo9g

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