Modeling institutional evolution Economic Systems

Modeling institutional evolution

Bilin Neyapti *

BilkentUniversity,DepartmentofEconomics,06800Bilkent,Ankara,Turkey

1. Introduction

Institutions are defined as commonly accepted rules of the game and their enforcement mechanismsthatresultfromrepeatedhumaninteractions(North,1990).Theintertwinednatureof therelationshipbetweeninstitutionsandeconomicperformancehasbecomeakeyfocusofthenew developmenteconomicsliterature.¹Thisstudyoffersaformalframeworktoanalyzethisrelationshipin viewofthetwoprominentapproachestoinstitutionaleconomics:transactioncostandcollectiveaction theories.TheformerofthesehasbeenpioneeredbyCoase(1960)anddevelopedasNewInstitutional Economics(NIE)byWilliamson(1985)andNorth(1990)amongothers,whilethelatterisduetoOlson (1965,1982).Thetwoapproachescomplementeachotherinunderstandingthenatureofinstitutions inagiveneconomyatagivenperiod,aswellasthefactorsthataffecttheirevolution.

Thetransactioncostapproachtoinstitutionalchangefocusesonthechangesinproductivefactors andtheirrelativepricesthatinturninfluencethenatureofinstitutionalarrangementsdemandedby ARTICLE INFO

Articlehistory:

Received10April2012

Receivedinrevisedform25April2012 Accepted15May2012

Keywords:

Institutionalevolution Punctuatedpath Growth

ABSTRACT

Thispaperproposesaformalframeworktoanalyzetheprocessof institutionalevolutioninrelationwitheconomicprogress.Institu- tionshavebothformal(F)andinformal(N)aspectsthatmayexhibit varyingprocessesofchange.Nishypothesizedtoevolvewiththe levelofcapitalstock,asinlearningbydoing,whereasFischosen optimallybyagovernmentthatmaximizesoutputsubjecttosocial and political costs. F and N together define the production technologyandaffecttheincomelevel.Consistentwithevidence, simulationsofthemodel’ssolutionrevealthatoptimumFexhibitsa punctuatedpattern.

ß2012ElsevierB.V.Allrightsreserved.

*Tel.:+903122902030;fax:+903122665140.

E-mailaddress:neyapti@bilkent.edu.tr.

1Theexamplesaremany,andinclude:Aron(2000),Clarke(2001),Cukiermanetal.(1992,2002),DollarandKraay(2003), EasterlyandLevine(2003),KnackandKeefer(1995),andRodriketal.(2002),tonamejustafewprominentones.

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Economic Systems

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http://dx.doi.org/10.1016/j.ecosys.2012.05.004

society. According tothis approach, institutions adapt both to each other and tothe changing economicenvironment.Collectiveactiontheory,ontheotherhand,focusesonthecircumstancesthat affect the formation and effectiveness of interest groups that facilitate institutional changevia affectinggovernments’decisions.²Whilethefirstapproachprovidesanefficientviewofinstitutional choice, collective action theory underlies the dynamics of institutional change, explaining the observedinefficiencieswithregardtoinstitutionalchange.³

In view of these two approaches, this paper models the formal and informal aspects of institutionsininteractionbothwitheachotherandwitheconomic progress.Astechnological accumulationanddemographicevolutionleadtochangesinthemeansofproduction,socialnorms andtraditionalwaysofdoingbusiness(informalinstitutions)continuouslyadapttothosechanges, albeitslowly.Whentheevolutionofinformalinstitutionsreachesalevelthatisnotsupportedwith theprevailing formalinstitutions, new interestgroupsemerge andsupport a changeinlegal frameworks.⁴Theprevailingformalstructureshavetheirpowerfulsupportgroups,however,who wouldresistthechange.Hence,allinstitutionalchangesresultingfromthesedynamicsmaynotbe Paretoimproving.

Sinceformalinstitutionalchangeiscostlyduetocreativedestruction,itisinfrequent,althoughit maybeabruptandofteninefficientduetothepowerstruggleofinterestgroups.⁵Olson(1982)calls thisphenomenoninstitutionalsclerosisandarguesthatitisamainfactorinexplainingthelowgrowth ratesinsomestabledemocracies.⁶Aspoliticiansfaceresistancefromspecialinterestgroups,reforms maygetdelayeduntilthecostsbecometoowidespreadandoverwhelming,sometimesleadingto crises. Institutionsare usually reformed when their benefitsexceedthe cost ofmaintaining the existingonesontheaggregate.Politicalandeconomiccrisesthatdestroytheexistingpower-balances oftengenerateanimpetusforradicalinstitutionalreforms.⁷Therefore,thepatternofinstitutional changeiscommonlyobservedtobepunctuated.

Inviewoftheforegoing,modelinginstitutionalevolutionshoulddistinguishbetweentwokey attributesofa productiontechnology:(i)thesetofinformalrules (N)thatisembedded in,or formedby,culturalorstructuralcharacteristicsofasocietyand(ii)thesetofformalrules(F)that definetheformalorganizationalcharacteristicsofproduction.Asproductionrelations(proxiedby N)evolvewiththeaccumulationofthefactorsofproduction,asinlearningbydoing,changesin lawsandregulationsthatorganizethoseproductionrelations(F)maylagbehind.Theadoptionof well-designedbankingorcompetitionlawsandfiscalpolicyinstitutionsare,forinstance,often observedtolagbehindtheneedsofaneconomyandusuallyfollowadiscontinuouspatternof development.⁸

Inadditiontodecisionsresultingfromdomesticpoliticalprocesses,internationaladviceoraid- conditionalitiesofinternationalorganizationsmayalsoplayaroleinformalinstitutionalchanges.

Manytransitioncountries,forexample,haveadoptedlawsbasedontheexperiencesofdeveloped countries(best-practiceinstitutions),althoughtheymaynotbeconsistentwithdomesticneeds.

Conflicts between legislations (F)and existing informal rules (N),however,have led to such reformsbeingdysfunctionalinseveralcases.⁹Inthesamespirit,bothBoettkeetal.(2008)and

2CoatesandHeckelman(2003)andCoatesetal.(2010,2011)provideempiricalevidenceinsupportofOlson’stheory.

Heckelman(2007)providesareviewofempiricaltestsofOlson’stheory.

3SeealsoNabliandNugent(1989).

4KemmerlingandNeugart(2009),forexample,showthesignificantroleofadevelopedfinancialsectoronpensionreforms inOECD.

5Afutureextensionwillbedevotedtoendogenizingthechangesinthepowerstructureintheeconomytoexplicitly incorporatethecollectiveactiontheoryandthusthepoliticaleconomyperspectiveintothecurrentmodel.

6AccordingtoOlson,stabledemocraciesaremostlikelytoaccumulatespecialinterestgroups,leadingtoinstitutional inefficienciesofthekindlatermodeledinAcemoglu(2006).

7See,forexample,DincerandNeyapti(2008)forempiricalevidenceonthesignificanteffectofcrisesontheadoptionof bankinglaws.

8CompetitionlawinTurkey,forexample,waslegislatedmorethanadecadeafteritsproposal,andmorethan100yearsafter itwasputintopracticeintheUS.

9Transitioneconomies,forinstance,haveadoptedlegislationsthatgrantindependencetotheircentralbanksorbanking lawsofdevelopedcountriesattheonsetofreformsintheearly1990s;thoselegislations,however,lackedthequalityof implementabilitywhentheywerenotaccompaniedbyotherreforms(seeCukiermanetal.,2002;NeyaptiandDincer,2005).

Williamson(2009)argue, andprovideempiricalevidence,thatNisamoredominantfactorin explainingthedevelopmentprocessthanF,whichneedstoadapttoNtohaveanimpactonthe level ofdevelopment.¹⁰Mathers andWilliamson (2011),WilliamsonandMathers(2011)and WilliamsonandKerekes(2011)allpointouttheimportanceofdistinguishingbetweenFandN,and reportevidenceregarding theirdynamicinterrelationshipwitheachotherandwitheconomic development.

Althoughtherehavebeenafewrecentattemptstomodelinstitutionalchange,thecomplexity ofthedynamicsinvolvingitspoliticalandeconomicaspectsleadsthesemodelstofocusonspecific aspectsofinstitutionalevolution.Foremostamongthem,Acemoglu(2006)developsapolitical economymodelbasedonex-antecharacterizationsofamiddleclass,workersandtheelitewho initiallyholdsallthepoliticalpower.Hearguesthatinefficientpoliciesresultunderbothfactor pricemanipulationand,thoughtoalesserextent,therevenueextractionincentivesoftheelite.In thatmodel,apotentialswitchofpoliticalpowertowardsthemiddleclassalsoresultsininefficient policychoices.Inefficientinstitutionsresult fromtheelite’sdesiretomaintainthesepolicies.

Utilizing the implementation-theory framework to combine social choice with institutional economics,Yao(2004)alsostudiestheissueofinstitutionalefficiency.Hefindsthatinstitutional changeissensitivetoincomedistributionandstickywithrespecttotheeconomicenvironment;

under several assumptions that define a good political process, efficient institutions arenot implementable.¹¹

The current study presents an original framework that utilizes capital accumulation and technologyadoptiontomodeltheevolutionarypatternofFandN.Themodelpredictsapunctuated trajectory for F, which is consistent with the observed evolution patterns of various formal institutions.Inwhatfollows,Section2statesthemainthesisofthisstudy.Section3outlinesthe formalmodel,followedbycalibrationsthatarepresentedinSection3.1.Thefindingsofthemodelare comparedtotheempiricalevidenceinSection3.2.Section4concludes.

2. Thehypothesis

Thispaperarguesthattheevolutionofformalinstitutionsusuallylagsbehindthatofinformal institutions;here,Ispecifically focus onthe intrinsicprocessofinstitutionaldynamicsrather than externally guidedor imposedchanges that may reverse this phenomenon. As informal institutionschangeasaresultoflearningbydoing,theprocessviawhichtheorganizationofwork changesasfactorsofproductionevolveandadapttotechnologywhichinturnfollowsacontinual progression, formal institutions change by legislations that are enacted by the government.

Althoughformal institutionsmay hencechangeovernight,the frequencyof majorchangesin themisrelativelylow.

Ina democraticsystem, governments facesome probabilityof replacement everyelection period and often focus on the demands of narrow constituencies rather than encompassing interests.¹²Untilthecontinuousprogressionininformalinstitutionsleadstotheemergenceof newinterestgroupsthatgainpoliticalpowertosupportformalinstitutionalreforms,government policiesarelikely to accommodatethe demands of existing interest groupstoincrease their reelectionchances.Forthesakeofsimplicity,thecurrentmodelrefrainsfrommodelingpolitical competitionandinterestgroupdynamicsexplicitly.Toaccountforthesedynamicsimplicitly,the costof changingF isassumed todependonthe stateofthe economy.Ina politicaleconomy extensionofthismodel,whichisthesubjectofafuturestudy,interestgroupdynamicswillbe modeledasafunctionofthestateoftheeconomy,incorporatingthecollectiveactionapproach explicitlyintothemodel.

10Boettkeetal.(2008)classifyinstitutionsasendogenousandexogenous,introducedbyforeignandindigenousactors,and arguethatindigenous-introducedendogenousinstitutionsarestickier.

11AssumptionsthatdefineagoodpoliticalprocessareMaskinmonotonicity,theconsiderationofindividualpreferencesonly, nointerpersonalutilitycomparison,andzeromonetarytransfers,thelastofwhichiscrucialforthereportedfinding.

12Agovernmentmayonlyserveencompassinginterestsfullyifitisagenuinemassparty(orifitisabenevolentdictator).

Whentherearepowerfulnarrowintereststhatincurthe(economicorpolitical)costsofchanging formalinstitutions,ittakestimeforpoliticianstorespond totheneeds buildingupforachange.

Hence,rather than adjusting to the changes in Nevery period, F would exhibit a stepwise, or punctuated,change,occurringinaradicalfashionthatfollowsaperiodofstability.Thenotionofa punctuatedevolutionarypathfollowsfromevolutionarybiology(seeEldredgeandGould,1972)that arguesthatspeciesexistforanextendedperiod(stasis)untiltheyaresomewhatabruptlyreplacedby otherspecies(whichhasposedachallengetoDarwin’sgradualistapproachtoevolution).Thenotion ofinstitutionsfollowinga punctuatedpathhasalsobeendiscussedoralludedtointhepolitical scienceliterature(see,forexample,Mahoney,2000;Pierson,2000)andinorganizationtheory(see Gersick,1991),althoughit hasnotyetbeenmodeledformally.¹³Themodelproposedherehasa potentialtoexplicitlyaccommodateforvariouspath-dependenceviewsofinstitutionalreproduction discussedinpoliticalscience.Gersickfurthernotes theusesofthis theoryintheexplanationsof scientific revolution, industrial innovation, organizational adaptation, adult development and in physics.Ina similar vein,Roland (2004)likensthedynamics of institutionalchangetobuilding tectonicpressures(intheformofgrowinginconsistencybetweenNandF),eventuallygivingwaytoa majorearthquake(anabruptchangeinF).

The main contribution of this paper is modeling formal institutional evolution in dynamic interactionwiththeeconomicgrowthprocess.Itsmainhypothesisisthat,facingthecostsofchanging institutionsthatareassociated withthechangingpreferences ofinterest groups,agovernment’s objective of maximizing its net benefit results in a punctuated nature of (formal) institutional evolution.

3. Themodel

Consideragovernmentthatchoosesthelevelofformalinstitutions(F)optimallytomaximizethe levelofoutput.Inreality,it canbearguedthat eachgovernmenthasaspecificconstituencyand optimallychoosesFbothtoserveitsredistributivepoliciesandtomaximizeitsreelectionchances, ratherthantomaximizeoutput.Thecurrentmodelproposesasimplesetupwhereitisassumedthat eachgovernmentcaresaboutthewholesocietyandassumestheentirecostofchangetoF;hence,the governmenttypedoesnotmatterwhilethestateoftheeconomydoes.Thissimplificationismerelyto focusonexplainingthedynamicsofinstitutionalevolution.¹⁴

Theproductionfunctionisinitsusualform,exceptthattechnology(A)iscomposedofformal (legal)andinformalinstitutions(norms),denotedbyFandN,respectively:

y¼AðF;NÞfðkÞ; where A⁰_1;2>0; A⁰⁰_1;2<0; f⁰>0 and f⁰⁰<0 (1)

whereystandsforpercapitaoutputandkiscapitalpercapita.Northdefinesproductionasaprocess comprisingbothtransformationandtransaction.Accordingly,thewaytechnologyisexpressed,A(F, N), reflects the transaction-cost reduction function of institutions.¹⁵ Thus, an increase in the institutionalquality,indicatedbyhighervaluesofFandN,implieshighertotalproductivityorlower transactioncosts.¹⁶Incorporatingtheroleofinstitutionsintothemodelinthisfashionmayappear

13Inthecontextoforganizationaltheory,Gersickarguesthatequilibriumissuchastatethatdeepstructuresdonotchangefor longperiodswhileinternalandexternalperturbationsaffectthesystemgradually.Healsonotesthat:PrigogineandStengers (1984,p.207)...havearguedthattraditionaldeterministicparadigmshavehad‘‘particularlyunfortunate’’effectsonthesocial sciences.Accordingtotheseauthors,thesearchforoptimizing,predictivetrajectoriesthatcanbeextrapolatedtoinfinityismisguided becausesuchapproachesaccountneitherfortheextremestowhichinertiamaydriveasystem....,asGould(1985)noted,effortsto unravelasystem’sworkingsbyminutelydissectingitspartsmissthepointwhentheparts’behaviorisdeterminedbythedeep structurethatorganizesthem.

14Inapoliticaleconomyextension,differentconstituenciesandredistributivepoliciesshouldbetakenintoaccount.

15Inaveryusefulrecentpaper,Halletal.(2010)modelgrowthwhereinstitutionsaffectgrowthviatheireffectonthe productivityof(physicalandhuman)capitalandprovideempiricalsupportforthisproposition.However,theirstudytakes institutionsasgivenandalsodoesnotdistinguishbetweenformalandinformalaspects.

16GranvilleandLeonard(2010)providerecentempiricalevidence,basedonthe89regionsoftheRussianFederation,that technologyisendogenoustoinformalinstitutions.

simplistic,thoughitnotonlyservesformathematicaltractabilitybutitisalsoconsistentwiththe manyconceptionsofinstitutions.

FandNcanbeviewedasindexnumbersthatrangebetween0and1(orsomeupperandlower valuessuchasF<F< ¯FandN<N< ¯N),where1representsthehighestquality ofaninstitutional attribute.¹⁷Totalfactorproductivity(A)increasesinbothFandN,butatadecreasingrate.

Informalinstitutionsevolveaccordingtotheprocess:

N_tþ1¼NtþgðktÞ; where g⁰>0; g<0; (2)

whichindicatesthatNprogresseswiththelevelofpercapitacapital,inlineswiththeendogenous growthliterature.HencetheprogressionofNexhibitslearningbydoing;thehigherthelevelofcapital, thehigherthequalityorlevelofnormsthatamasswithit,definingahigherleveloftechnology.The equationcanalsobewrittenas:Nt¼NOþPt

i¼1gðk_tiÞ,implyingthatthequalityofnormsatany given time is givenby aninitial levelof normsthat is augmentedby the‘‘stockof know-how’’

accumulatedovertime.

Capitalperlaborevolvesaccordingtothestandardlawofmotion:

ktþ1¼ð1

d

ÞktþIt (3)

where

d

is therateofdepreciationand It isthelevel ofinvestmentat time t.¹⁸Without lossof generality,itcanbefurtherassumedthatpopulationgrowthiszeroandhenceinvestmentisequalto thesavingsminusdepreciationallowance,suchthatIt= syt

d

kt,wheresisthesavingsrate.¹⁹

Amendingformalinstitutions,orchangingtheproductiontechnology,involves costscoinedas creativedestruction,alongwithitsprojectedbenefits.Hence,theincumbentgovernmentchoosesFto maximizeoutput,netofthecostofchangingF.Thesecostsmaybeintheformofincreasedwelfare spendingtoaccommodatethelaborthatbecomesidleasaresultofthenewlyadoptedtechnologiesor modifiedorganizationalstructures.²⁰Theextentofthesecoststendstoberelatedpositivelywiththe magnitudeofachangeinF,andnegativelywiththeprevailingdistancebetweenFandN.²¹Thefirstof theseeffectsarisessinceeachlevelofFislikelytobeassociatedwithcertainspecialinterestgroups whomayresistitschange.IfoneconsidersthatNrepresentstheencompassinginterestsinasociety, however,thecloserFistoN,thelesssociallynecessaryoreconomicallyefficientwouldbeachangein F;hence,thelesswouldtherebepoliticalsupportforachangeinF.Hence,thecloserFistoN,the greaterthecostofchangingF.Inviewoftheabove,thegovernment’sproblemcanbewrittenas:

MaxF yC

D

F;F N

 

; where C⁰₁>0 and C⁰₂>0 (4)

Themechanicsofendogenousinstitutionalchangecanbesummarizedasfollows:thelevelof output,andthussavings,determinesthelevelofcapitalaccumulation,whichinturnleadsNtoevolve vialearningbydoing.Ineachperiod,thegovernmentoptimallychoosesFtomaximizethenetbenefit givenbyEq.(4).ThemodelimpliesthatwhileanincreaseinkleadsNtoincreaseandinturnaffectsthe optimalchoiceofF,FaffectsthelevelofNthroughitsaffectony.Hence,FandNinteractcontinuously, reflectingimplicitlythatthecostofchangingFhingesuponthestateofcollectiveaction.Hence, althoughhighervaluesofFmayreducetransactioncostsandthereforeincreaseoutput,theymaynot beoptimalforagovernmenttoincreaseF.

17Theliteratureprovidesmanyexamplesofquantificationofinstitutionalqualityonanordinalscale.See,forexample, CentralBankIndependenceIndices(Cukiermanetal.,1992,2002);CorruptionPerceptionIndex(TransparencyInternational), EconomicFreedomoftheWorldIndex;andGovernanceindices(theWorldBank),tonameafewamongstthemany.

18Iassumefullinvestmentefficiencyinthesensethatallinvestmentspendingbecomesanadditiontothecapitalstock.

19Capitalaccumulationmayalsobeconsideredtoinvolveashocktermsuchthatkt+1= (1 d)kt+ It+ et,wherealargeetstands foramajorleapinthecapital/laborratioduetoeitherdestructionofsomeproductiveforces,ininstancessuchaswarornatural disastersorasaresultofmajortechnologicalinnovations.Significantchangesinthestructureofproductionarealsooften associatedwithsignificantchangesinthepowerstructureandhencehaveimportantpoliticalimplications.Transitionfrom feudalismtocapitalismandsocialismentailedsuchmasstransformationsfromextensivetointensivelaboruseandthe IndustrialRevolution.

20Moscoso-Boedo(2010)incorporatesthesecostsintothelawsofmotionofthephysicalandskilledworkerstocks.

21Inapoliticaleconomyextension,thesecostscanbedefinedastheweightedsumofthecostsincurredbydifferent constituencies.

Theabovedynamicscanbesummedupbythefollowingsequentialpattern:

(i) GivenNtandFt,ktdepreciateseachperiodwhilenewcapitalaccumulatesduetosavingsthatare fullyturnedintoinvestments.

(ii) Nt+1evolveswithkt.

(iii) Basedonthelevelsofkt+1andNt+1,aswellastheratioofFttoNtinthecurrentperiod,optimalFt+1

isselectedtomaximizeyt+1–ifoptimalFt+1ishigherthanFt,andlessthanNt+1.²²

3.1. Simulations

In ordertoobtainexplicitsolutionsforthemodelandtosimulatethetrajectoryofoptimalF, Eqs.(5)–(8)areconsideredinplaceofEqs.(1)–(4).Thegovernmentsolvesthefollowingproblem, wheretheproductionfunctionisgivenbyðF_tþ1N_tþ1Þ^uk^b_tþ1:

Max_Ftþ1 ðF_tþ1N_tþ1Þ^uk^b_tþ1Cð

D

Ft;N_tþ1Þ (5) where the technology exhibits complementarity between F and N such that (for F < N), total productivitygetshigherthecloserthevaluesofFandN).

Thecostfunctionisgivenby:

Cð

D

Ft;N_tþ1Þ¼

a

ðFtþ1FtÞ Ft

Nt

 

; where

a

>0: (6)

Inaddition,thelawofmotionforNandFisgivenbyEqs.(7)and(8)²³: N_tþ1¼NtþN½1=ð100logðktÞ

t (7)

k_tþ1¼sðFtNtÞ^uk^b_t þð1

d

Þkt; where 0<s;

u

;

b

;

d

<1: (8) ItisfurtherassumedthatFt+1>FtandFt+1 Nt+1.Theformeroftheseassumptionsismadeonthe groundsthat,usually,theformalchangesarejustifiedandapprovediftheyimplysomeimprovement overtheexistingones;eventhoughtheoppositecasemayexistinreality,thecurrentstudydoesnot addressitasitisrare.Thesecondassumption,inaway,representsstatus-quobias;ifFislettoexceed N,itwoulddistorttheexistingonesandgenerateitsownnewinterestgroups.

After substituting(6) in(5),thesolutionof theproblem givenby Eq.(5)yieldsthefollowing optimalpathforFt+1:

F_tþ1^ ¼

a u

Ft

Nt

  1

N^u_tþ1k^b_tþ1

" #ð1=ðu1Þ

; if

a u

Ft

Nt

  1

N_tþ1^u k^b_tþ1

" #ð1=ðu1Þ

>F

F; otherwise

8>

<

>: (9)

Hence,thesolutionoftheaboveproblemsatisfiesEqs.(5),(6)and(9).GiventheinitialvaluesofNand F,thevaluesofN,F,k,andycanthusbesimulatedtoyieldadynamicpath.

Fig.1showsthesimulationsofF*andkusingasetofreasonableparametervaluesfor

d

,

b

ands.²⁵ Thefigureisbasedon

a

= 50and

u

= 0.5,althoughdifferentvaluesoftheseparametersleadtosimilar patterns.²⁶Theinitialcapitalintensityisnormalizedto1.Thefigurehasthreepanelscorrespondingto threedifferentsets ofinitialF and Nvalues thatare considered toproxydifferentdevelopment scenarios.Tobeabletofocussolelyonthedifferencesintrajectoriesthatarisefromdifferentinitial

24

22ThelastassumptioncanbemadebasedontheendogenousevolutionofF,inwhichcasethedemandsofinterestgroupsare limitedbythelevelofN.

23ThefunctionalformgiveninEq.(7)ischosentoobtainasmoothprogressionforN.

24Simulationsyieldreasonableresultsforu 0.96.

I I nitial : N = 0 . 3 a n d I n i t i a l F=0.1

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40

1 5 9 13 17 21 25 29 33 37 41 45 49 years

F*

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00

1 5 9 13 17 21 25 29 33 37 41 45 49 years

K

II. Initial N=0.7;I nitial F=0.5

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40

1 5 9 13 17 21 2529 33 37 41 45 49 years

F*

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00

1 5 9 13 17 21 25 29 33 37 41 45 49 years

K

III. Initial N=0.7;I nitial F=0.2

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40

1 5 9 13 17 21 25 29 33 37 41 45 49 years

F*

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00 40.00

1 5 9 13 17 21 25 29 33 37 41 45 49 years

K

Fig.1.Trajectories(50years)ofF*andk(assumingk = 1;a= 100;b= 0.2;d= 0.08;u= 0.8ands = 0.2).

valuesofinstitutions,therestoftheparametervaluesandvariablecalibrationsarekeptconstant acrossdifferentscenarios.

The first panel in Fig. 1 represents the case of developing countries that have low levelsof institutionaldevelopment, withless than 0.5 initial values for F and N. The second represents developedcountries,wherebothtypesofinstitutionalindicesarerelativelyhigh(F = 0.5andN = 0.7), andthethirdonedevelopedcountrieswherenormsaredevelopedbutformalinstitutionsarenot, whereFandNaretakentobe0.2and0.7respectively.Forthislastcase,onecouldconsiderthe2007 crisisthat pointed at theneed ofsubstantial reforms for thefinancial institutions ofdeveloped countries.Onecanobserveclearly,basedonallthepanelsinFig.1,thatthetrajectoriesofF*reflecta punctuatednature.Inaddition,acomparisonofthelevelstowhichF*andkconvergeinallthree panelsindicatesthatconvergencemayberealizedandthepoverty-trapmaybeavoidedinthecaseof continuousinstitutionalreforms,evenwheninstitutionsarelowqualitytostartwith.

Observation1. Theoptimalpathofformalinstitutionalreformdepictsapunctuatedpattern.

Totestthesensitivityoftheresultstothemodelparameters,greaterkand

b

valuesarechosento representdevelopedcountries.Althoughthesemodificationsleavethenatureoftheresultsvirtually thesame,itisobservedthathigherkslowsdownthereforms,whereashigher

b

appearstoleadto fasterupdatesofF*.Inaddition,convergenceisobservedtobereachedacrossdifferentvaluesofk, keepingtherestofthemodelparametersandinitialFandNvaluesthesame.

Observation2. Incomeconvergencecanbeachievedviainstitutionaldevelopment.

Furthersimulationsareperformedtoexaminethesensitivityofthereportedfindingstothemodel parameters.²⁷Keepingotherparametersconstant,itisobservedthatlowervaluesof

u

generallylead tolowersteady-statevaluesandmoreprolongedperiodsbeforeachangeinF*occurs(exceptfor N > 0.5).Theeffectof

u

onF*getsweakerasthevaluesofincomeshareofcapital(

b

)getbigger.The positiverelationshipbetween

b

andF*alsogetsweakerthegreater

b

is.Inaddition,thenegative relationshipbetweenthecostofchangingF(

a

)andF*increasesas

b

increases.Thefollowingpartial derivativessummarizetheseobservationsthatareallinlinewithexpectations.²⁸

@

F^

@a

^<0;

@

F^

@b

^>0;

@

F^

@u

^>0;

@

²F^

@a



@a

^0;

@

²F^

@b

:

@b

^<0;

@

²F^

@u



@u

>0...if

u

<0:8

<0...otherwise;



@²F^

@a@b



  <0;

@

²F^

@b



@a

^{0; @}

2F^

@u@a0; _@b^@2F_@u^ >0...if

u

<0:8

<0...otherwise



Astheabovecomparativestaticsindicate,thecostofchangingFdoesnotaffecttheresponsivenessof optimalFtotheincomesharesoftechnologyandcapital.Inaddition,asexpected,theeffectsof

a

,

b

and

u

onF*generallyincreasein

u

anddecreasein

b

.Simulationsfurthershowthecomplementarity betweenNandF;theoutputeffectofNincreasesinFandviceversa,foralllevelsofinstitutional development.²⁹ItisalsoobservedthatthecontributionsofbothNandFonoutputincreasein

b

, althoughatadecreasingrate.Basedontheseobservationsandimpliedtrajectoriesofthemodel,the followingobservationscanbemade.

25NadiriandPrucha(1996)showthatthedepreciationrateforphysicalcapitalis0.06andforR&Dis0.12fortheUS.In addition,Mankiwetal.(1992)showthatb= 1/3forUS.AccordingtotheWorldDevelopmentIndicatorsdatabaseoftheWorld Bank,theworldaverageofthesavingrate(grosssavingsaspercentageofGNI)hasbeenbetween0.20and0.23duringthepast threedecades.

26Simulationsbasedonalternativeparametervaluesareavailablefromtheauthoruponrequest.

27Thedataandgraphsareavailableuponrequest.

28ThecomparativestaticresultsareobtainedusingtheMATLABprogramandsimulations.

Observation3. AssumingaCRTSproductionfunction,thesmallertheincomeshareofcapital,themore gradualistheprogressionofF*.

Observation4. Thenegativeeffectofthecostofformalreforms(

@

F^/

@ a

)ismitigatedbytheincreasein theincomeshareofcapitalortechnology(for

u

<0.2).

The last two propositionshelp to explain whythe convergencebetween less developed and developedeconomiestakealongtimetooccur.Afocusonthereductionofthecostofformalreforms inlessdevelopedcountriesthereforeappearstobeanimportantpolicyissue.

Appendix1ashowsthetrajectoriesofoptimal-Fandkinrelationto

u

and

a

.Thegraphsindicate that,eventhoughbothvariablesfollowanupwardtrendforarangeof

u

values,thecostofreform lowers thesetrajectories severely. Appendix 1b shows that increasing the contribution of F on productivity(especiallyfor

u

>0.8)substantiallyincreasesthelong-termoptimalcapital.

SinceNaccumulatescontinuously,itmayhaveincreasingreturns.Toaccountforsuchapossibility, Ialsoexploredthefollowingformoftheproductionfunction:ðF_tþ1^u1 N_tþ1^u2Þk^b_tþ1,where

u

2>0.While thetrajectoriesinthiscaseindicateonlyaslightlymoreupwardtrend,thebasicobservationsonthe trajectoriesremainvirtuallyunchanged.

3.2. Evidence

Institutionalchangeisa continuousprocessandconcernsnotonlydevelopingbutalsodeveloped countries.The implicationsoftheabovemodel canindeed be exemplifiedinthe attemptsofmany developednations’governmentstorevisetheirfinancialregulatoryandsupervisoryframeworksinthe aftermathofthe2007globalfinancialcrises.³⁰TherecentcrisisrevealedthenecessityforFtocatchupwith Ninthefinancialsector,whereNinthiscaserepresentstheincreasedriskappetiteinfinancialtransactions andrapidlydevelopingfinancialengineeringtoolsinagenerallyprosperingglobalenvironment,andF representstheregulatoryframeworkthatneedsreformsoastoreduceoreliminatethetransactioncosts relatedwiththeusageofthosetools.Crisesareamongtheprimaryfactorsthattriggerinstitutionalchange;

theyarealsoobservedtoleadtoparadigmshiftsorcyclesineconomicthinking.Sinceforeseeingthe dynamicinteractionsbetweeninstitutionsandeconomicdevelopmentisnotfullypossible,however, neitherisreforminginstitutionsonceandforalltoinsureagainstallpotentialeconomicrisks.

Aseachformalinstitution mayinteractwithadifferentsetofinformalinstitutionsandhence affectsdevelopmentthroughvariousdirectorindirectchannels,providinganempiricalexplorationof themodels’predictionsisbeyondthescopeofthecurrentpaper.³¹Instead,thispaperpavestheway for such research by drawing attention to the evidence regarding the evolution of some well- documentedformalinstitutionalmeasuresthatsupportthecurrentmodel’spredictions.

Williamson(2009)pointsoutthatmeasuringFisratherdifficultasmanyindicatorsaretheoutcomes of institutions rather than the institutions themselves (among them she counts the governance indicatorsofKaufmannetal.andtheICRGindex).Inviewofthis,WilliamsonandKerekes(2011)follow Gleaseretal.(2004)andtakeintoaccounttheconstraintsontheexecutive,judicialindependenceand constitutionalreviewtomeasureF.³²SobelandCoyne(2011)alsousetheconstraintsontheexecutive, democracyand autocracy(PolityIVmeasuresofMarshalletal.,2011)tomeasureF.Mostofthese variables,however,arenotavailableonatime-seriesbasisandhencecannotbeemployedtoobservean evolutionarypatternofthesortinvestigatedabove.Thevariablethatisavailableonatime-seriesbasis

29ThisisincontrastwithAhlerupetal.(2009)findingofsubstitutabilitybetweenformalinstitutionsandsocialcapital.

However,theexamplethatAhlerupetal.provideonthesmallertheeffectofNthehighertheincomelevelisconfirmedbythe currentmodel.

30Inarelatedstudy,VandeKlundert(2010)modelsinstitutionalchangeasrecurrentwavesinthecaseofacapitalistsociety.

31AresearchinthatspiritisprovidedbyPosen(1995)inthecontextofcentralbankindependence,wheretheauthorargues thatitisnotthecentralbanklaw,buttheunderlyingfinancialconsensusthatmayalsoleadtotheadoptionofthelaw,that mattersfortheoutcomeofpricestability.

andappearstobetheclosestcandidatetomeasurethestatusofformalinstitutionsinamacroeconomic senseisthereforethePolityIVvariable.³³Fig.2demonstratestheevolutionofthisvariableinasampleof selectdemocraciesforaspanofmorethanacentury,supportingthepatternpredictedinthemodel describedintheprevioussectionandinFig.1.Itshouldbenotedthattheupwardbutpunctuatedpattern that the current model conjectures assumes away, for simplicity of the analysis, the effects on institutionsofdisruptionscausedbyextraordinaryeconomicorpoliticalepisodes.³⁴Inadditionto developedcountryexamples,thefigurealsoshowsthatCostaRica,anexceptionaldevelopingcountry withastabledemocraticregime,providesanexampleforanupwardpunctuatedpatternofPolityIV indexsincetheearly1800s.³⁵

0 2 4 6 8 10 12

1867 1876

188 5

1894 1903

191 2

192 1

1930 1939

194 8

1957 1966

197 5

1984 1993

200 2

Canada USA UK

-4 -2 0 2 4 6 8 10 12

1838 1848

1858 1868

1878 1888

1898 1908

1918 1928

1938 1948

1958 1968

197 8

198 8

1998 200

8

Cos ta-Rica

Fig.2.Polity2indicesforasampleofcountries.

Source:Marshalletal.(2011).

32Tabellini(2010)usestheWorldValuesSurvey(WVS),andWilliamsonandMathers(2011)focus,inparticular,onthetrust, self-determination,respectandobedienceaspectsofWVSformeasuringN.TheWVSdataset,however,haslagsinthetime-series reportedforeachcountry;hencethissectiondoesnotreportevidenceonthepatternofN,butfocusesontheevolutionary processofF.

33PolityIVisanindexrangingbetween10and10,whichmeasurestheextentofautocracy/democracy.

In the following, the evolutionary pattern of specific monetary institutions, for which legal measurements are available, is presented. Fig. 3 shows sample trajectories of central bank independence(CBI)andbankregulationandsupervision(RS).Thefirstofthesegraphsdemonstrates

Degree of Central Bank Independence

(Data is based on Cukierman et al., 2002)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

1970 1972

1974 1976

1978 1980

1982 1984

1986 1988

1990 1992

1994 1996

1998 2000

Index of Central Bank Independence

Czech Republic Estonia Poland Chile

Bank Regulation and Supervision Quality

(Data is based on Dincer and Neyapti, 2007)

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Index of Bank Regulation and Supervision

Brazil UK Turkey Poland Azerbaijan

Fig.3.Sampletrajectoriesofinstitutionalreforms:someevidence.

34Unlikethecontinuous,thoughpunctuated,upwardpatterninthePolityIVindexobservedinCanada,UKandtheUSA,the indexisobservedtofallinGermanyandFranceduringWorldWarII,butcatchingupwiththosereportedaboveshortlyafter.

Likewise,becausemanydevelopingcountrieshavehadintermittentperiodsofautocraticregimes,anupwardevolutionary patternisnotobservedinthoseoveralongperiodgoingbackinhistory.

thechangesinCBIinthreeformerlycentrallyplannedeconomiesandChile.Inthisgraph,whileCBIin Chileshowsacontinualprogression,CBIintransitioneconomiesshowsabruptchangespursuantto thewide-rangingmarketreformsthatfollowedmajorpoliticaloverhauls.Itcanbearguedthatthe costofmodifyingformalmechanismsbecamemucheasierfortransitioncountriesthatunderwent majorchangesinthepoliticalpowerstructuresaccompanyingeconomiccrises.Theuppergraphof Fig.2alsoprovidesexamplesinsupportofinstitutionalconvergence.

ThelowergraphofFig.3demonstratesmuchslowerchangesinBrazilandtheUKwithregardtoRS thanintransitioncountries.Inlinewiththeprevious,apossibleexplanationforthisobservationcould betheexistinginterestgroupresistancetoachangeinthestatusquointheformertwocountries,in contrastwiththetransitioncountriesthat revisedtheir legalframeworksfollowingseverecrises whoseeffectswereall-encompassing.ContrarytotheuppergraphofFig.3,however,thedifferent levelsofRSobservedindifferentcountriesprobablyindicatethatmanycountriesarestillfaraway fromthesteady-statelevelofRS.Inotherwords,comparingthetwographsseemstoexemplifythe factthatwhilethehighorhyperinflationaryepisodesthatcausedgreatwelfarelossesduringthepast decadeshaveledthecentralbankreformstohavebeenwidelyachievedaroundtheworld,therestill seemstobealongwaytogowithregardtothereformsinthefinancialandbankingsectorsinmany countries.

4. Concludingremarks

Thisstudyproposesanoriginalformalmodelofendogenousinstitutionalchangevisa` viseconomic growth.Technologycomprisestwoattributesthataffectproductivityandtransactioncostreduction:

informalwaysofconductingbusiness,ornorms,andformalinstitutionsthatregulate,superviseand enforcethoseconducts.Whileinformalinstitutionscontinuouslyevolveasaresultoftechnological know-how,formalinstitutionschangeviagovernments’optimizingbehaviorandusuallyfollowa punctuatedpattern.Thispatternstemsfromthecreativedestructionthatinstitutionalchange,asany technologicalchange,mayleadto;suchdestructionisduetoeconomicandpoliticalcostsincurredby

35CostaRicastandsoutasanexampleofanundisruptedpatternofevolutionandhenceitwouldnotbeappropriateto evaluate,basedonthissingleobservation,therelevanceoftheobservationsmadeearlierinthispaperwithregardtodeveloping countryperformance.

Fig.A1.SampletrajectoriesofF*andkovertimeanda(giveninitialvaluesandmodelparameters:F0= 0.1;N0= 0.5;k0= 1;

d= 0.08;s = 0.2;b= 0.3;a= 50).

Fig.A2.SampletrajectoriesofF*andkovertimeandu(giveninitialvaluesandmodelparameters:F0= 0.1;N0= 0.5;k0= 1;

d= 0.08;s = 0.2;b= 0.3;a= 50).

prevailinginterestgroups.Hence,themodelisconsistentwiththetwomainstrandsofinstitutional approaches: transaction cost and collective action theories. Simulations of the model reveal a punctuatedpatternofevolutionforformalinstitutions.Inaddition,incomeconvergenceseemstobe achieved via institutional development. The findings are consistent with the evidence on the evolutionarypatternofsomeobservedmeasuresofformalinstitutionalchange,namelythePolity2 index,centralbankindependenceandbankregulationandsupervisionquality.

Acknowledgements

IamverygratefulforthecommentsofEsraDurceylan,CagriSaglamandZekiSarigil.Iamalso indebtedtotwoanonymousrefereesfortheirinvaluablecommentsandsuggestions.Lastbutnot least,IthankM.KeremYukselforhisexcellentresearchassistance.

Appendix1

SeeFigs.A1andA2.

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