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.

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.,

1
The description here of institutional development is taken from North (1991), with clarifications and
extensions to facilitate its comprehension.

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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 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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Notes on the Institutional Context

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 long-
distance 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 develop
standardized weights and measures, units of account, a medium of exchange, notaries,

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Notes on the Institutional Context

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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Notes on the Institutional Context

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.

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

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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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Notes on the Institutional Context

Path dependency explains the development and persistence of institutions, whether they
are regulatory, normative or cognitive. Rules of the game once accepted often are locked-
in, 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 time-
consuming 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.

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 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 involves

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Notes on the Institutional Context

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, decision-
makers who are embedded in a home institutional context may hold a biased view of these
emerging markets.

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Notes on the Institutional Context

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

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Notes on the Institutional Context

scores in 2005, BRIC countries hardly differed (composite scores were all 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 finer-
grained 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.

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 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.

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Notes on the Institutional Context

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.

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

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Notes on the Institutional Context

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).

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.

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Notes on the Institutional Context

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 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.

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Notes on the Institutional Context

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 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

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Notes on the Institutional Context

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.

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.”

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Notes on the Institutional Context

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 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 medium-
sized 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

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Notes on the Institutional Context

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.

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.

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Notes on the Institutional Context

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. 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

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Notes on the Institutional Context

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.

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

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Notes on the Institutional Context

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
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 so-
called “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.

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Notes on the Institutional Context

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 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.

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Notes on the Institutional Context

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.

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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