Conceptualizing the Dynamics of Institutional

Change

Masahiko AokiStanford University

ESNIE May 5, 2005: Cargese Corsica

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Questions People say：“ institutions matter.” If

institutions are nothing more than codified laws, organizations and other such explicit, intentional devices, why can’t badly-performing economies design (emulate) “good” institutions and implement them?

Let us ask: How do institutions change? Or, why do they not change as people might like? An answer depends on what institutions are.

We would also like to understand in what sense “history matters” in institutional development.

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Recent Literature Douglass North, Understanding the

Process of Economic Change, CUP, 2005.

Avner Greif, Institutions: Theory and History, CUP forthcoming.

Gerald Roland; « Fast-changing and Slow-changing Institutions ».

M. Aoki, Towards a Comparative Institutional Analysis, MIT Press, 2001. Referred to as TCIA hereafter.

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Plan of the lecture First, I propose a quasi-game-theoretic,

equilibrium concept of institutions. The concept is useful for an understanding

of interdependencies/linkages of human behaviors and associated institutions across various domains (economic, social, organizational and political).

Then, I discuss how institutions change as a kind of equilibrium shift, of which direction is conditioned by dynamic interactions of games across the domains.

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Alternative game-theoretic concepts of institutions Game form:

The unit of analysis: Set of players & activated sets of action choices = the domain;

The rule of the game: the consequence function which maps the domain to the range of physical consequences (its composite with the utility functions = pay-off functions)

What are institutions? Players (=organizations)? Nelson (ICC 1994) Rule of the game (exogenous constraints on the domain/con

sequence function: law, social norms, etc.)? North, Williamson

Equilibrium outcome? Young (1998), Aoki, Dixit (2004) Synthesis of all plus values? Greif (2005)

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Institution is a summary representation of invariant and salient features of a (Nash) equilibrium path, held as shared beliefs of the players about how the game is being repeatedly played.

Institution as a Nash

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Caveats and immediate defense against possible objections I have not specified game yet! I will do so shortly. I ha

ve not refined the equilibrium concept beyond Nash. The Nash concept is only a representation of self-enforceability.

Don’t confuse Nash equilibrium with Pareto-efficiency. The word “beliefs” is used in the sense of “expectatio

ns”. No normative implication at this moment. Is the equilibrium concept incompatible with change?

I partially follow Schumpeter who was originally a Walrasian economist and conceptualized the innovation as creative destruction of equilibrium (equilibrium shift).

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Endogenous-exogenous, objective-subjective, enabling-constrainingdualities of institutions

strategies equilibrium

jointlyconstruct

Beliefscoordinate

constrain/enable summarized as, and reconfirms

endogenous rules of the game

play of the game

institution

individual

player

domain of

the game

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Institutional arrangements as equilibrium linkages

Complex over-all institutional arrangements evolve, as various domains (economic, social, political and organizational) become linked/inter-related in an equilibrating manner.

There are two types of equilibrium linkages: complementarities and linked games.

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In what sense “history matters”? The specification of institution-free rule of the game is not possi

ble (A. Field). Where do the rules of the game come from? I seek the direction of inevitable infinite regression toward historical past (rather than meta-game).

A domain is conditioned by mental states and acquired competences of players and may comprise organizations as players. The consequence function is conditioned by technology, statutory laws, and institutions in other domains. History matters in all these. [Statutory law is not by itself an institution, unless the enforcer of the rule of law is believed to have the ability and motivation to enforce it.]

The selection of an equilibrium (an institution) out of possible many may be conditioned by dynamic linkages of various domains. Thus over-all institutional arrangement may be coherent, reinforcing, diverse across economies, Pareto-suboptimal (not Pareto-rankable) and path-dependent.

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Primitive domain and proto-institutions Repeated economic exchanges

Trust, gift exchange (Carmichael and MacLeod) The commons

Customary rights, tragedy Asymmetric cooperation

Asymmetry in complementarity between residual rights of control and effort → 　 Integration of property rights in physical assets and hierarchy (Grossman and Hart).

Symmetric cooperation Free-riding?

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Social exchange domains Non-economic goods/bads (social symbols, la

nguages) that would directly affect the payoffs of recipient agents, such as esteem, sympathy, approval, accusation and so on, are unilaterally delivered and/or traded with “unspecified obligations to reciprocate”, and sometimes accompanied by gift-exchanges.

Expected surplus from repeated exchanges may be conceptualized as “social capital”.

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Institutional linkage of domains (1): Linked games

Games are “linked”, if one or more players choose strategies across more than one domains in a coordinating manner. Because of possible externalities created by

such linkage, a behavioral pattern that is unsustainable in a single domain may become sustainable and becomes a viable institution.

For example, punishment mechanism may become self-enforcing even if players are short-sighted and/or not-excludable in a single domain.

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Social-embeddedness On one hand, values and norms may be perceived as

exogenously given by individuals but actually they are endogenously shaped by them, “in part for their own strategic reasons.” On the other hand, agents in markets and organizations in modern society generate trust and discourage malfeasance by being embedded in “concrete personal relations and structures (networks).” (Granovetter)

Community of traders Community norms in the use of commons, professional reput

ation in open software development, etc.

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Bundling Bundling by an internal player

Bundling of multiple contracts → factory, multi-vendor subcontracting system, venture capital, linked contracts.

Bundling by a third party player. The Law Merchant, markets under the rules of law Contingent governance of (symmetric) cooperation

(team) by the third party as the budget-breaker (cf. TCIA, ch 10).

Note that the third party itself is a strategic player.

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The state in political domain

The state as an equilibrium with the government (a third party) as the property rights enforcer cum tax collector → 　“ the fundamental dilemma of the political economy” (Weingast). Democratic, corporatist, collusive, develop

mental, delegated bargaining states (cf, TCIA, ch. 6)

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Institutional linkage of domains (2): institutional complementarities

U(x’) - U(x”) increases on domain X for all the players when z’ rather than z” prevails in domain Z [it does not require that U(x’) - U(x”)>0]. Then x’ and z’ (alt. x” and z”) complement each other. → institutional complementarities 　 Codetermination + corporatist state, life-tim

e employment +main bank system (cf. TCIA, chs. 10 and 12)

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Institutional change Internal dynamics of game induces changes in paramet

ers of the domain (skills, technology, etc.). With environmental changes, sub-optimal mutant strate

gy becomes viable and/or the experiments of new strategies are triggered. The sets of activated choices expand.

When new strategic choices converge to a new equilibrium, a new institution emerges. Its characteristics are conditioned by the dynamic linkages of domains.

The selection of an equilibrium out of possible many may also be influenced by predictive beliefs by “entrepreneurs” and/or normative beliefs of charismatic leader (as distinguished from “share beliefs), as well as the enactment of statutory law.

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Reconfiguration of linkage

The same social norm embeds different domains of economic transactions over time. Integrated firms → 　 industrial districts. Community norm in the transition to market (Aoki a

nd Hayami) Slow-changing institutions and fast-changing instit

utions (Roland) Schumpeterian dis-bundling and bundling

Dis-integration of large firms and emergence of supply-chain, modular entrepreneurial firms

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Dynamic institutional complementarities

Momentum theorem (Milgrom, Roberts and Qian): Even if the initial level of human resources supporting institution A is low, the presence of complementary institution B may amplify the impact of a policy to induce A.

Role of Hong Kong in the China’s market transition Conversely, even if a law is introduced to induce instit

ution A, the absence of complementary institutions B may make its realization difficult.

Difficulty of enforcing the market-oriented corporate governance when the rule of law does not prevail.

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Path-dependence and novelty in institutional change

While diachronic social embededness and dynamic complementarities constrain/enable the direction of searches of new strategic choices in path-dependent manner, the Schumpeterian mechanism may bring in an innovative element into an new institution.

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Emergence of Silicon Valley model as a Schumpeterian dynamics

The bundling of Coasian employment contracts by the “firm”.

Challenge of organizing complex tasks in the context of a hierarchy. The decomposition of a complex system into modules (design tasks) with the centralized specification of interface rules (design rules): IBM System/360.

Separation and re-bundling of modules: Exits of engineers from IBM and the emergence of looser bundling of venture capital- entrepreneur relationships (VC bundling).

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What kind of new values are created by VC bundling? VC finances multiple entrepreneurs for the

same project (design of a module) and selects a successful design through stage financing. Option value (Baldwin and Clark 2000):

multiple experiments create option value net of multiple costs under uncertainty.

Tournament value (Aoki 2001): Under tournament competition, marginal effort by the entrepreneur creates additional value for him (i.e., increased probability of winning prize) so that higher effort can be induced.

Synthesis (M. Aoki and H. Takizawa, J. Comparative Econ, 2002).

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Modularity as an institution of Schumpeterian innovation Design of modules of a system can be

improved on, independently of each other, as far as they are consistent with the interface rules. Thus the system can be evolutionarily innovated by continuous re-bundling (“new combination”) of emergent new designs.

An entirely new system may be created by bundling modules from different systems. (“Porting” Baldwin and Clark). Internet, ICT home appliances.

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Why SV phenomenon occurs in certain places, but not in others. Dis-bundling of existing bundling may be hampered by

inertia (social embeddedness), resistance of player deriving rents from status quo, the presence of robust complementary institutions.

Institution of life-time employment prevents exits of qualified engineers from established integrated firms.

Dis-bundling and re-bundling may be facilitated if embedding norm favors mobility, complementary institutions/competence/law exist, etc.

Theorem: “The more the judgment of VC is believed to be precise by competing entrepreneurs, the more efforts would be elicited from them.” (TCIA ch. 14)

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Thank you for listening.