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2DOI: 10.29141/2658-5081-2023-24-1-1 EDN: FEROML JEL classification: E02, E14, O43 Oleg S. Sukharev Institute of Economics of RAS, Moscow, Russia
Institutional change and the quality of rules in ensuring economic growth
Abstract. The quality of existing rules, as well as their change, impacts on economic growth. Meanwhile, numerous scientific contributions paint a very truncated picture of this influence. The study aims to identify the relationship between institutional change, the quality of rules, and economic growth through the construction of a theoretical model. The theory of economic growth, North and Olson's theory of institutional change as well as the author's theory of malfunctions constitute the methodological basis of the research. The methods include taxonomic analysis and modeling. The study demonstrates that the quality of institutions, and moreover, the institutional environment, can be assessed by measuring their malfunction, as well as using standard methods from the field of economics of quality. As a result, the paper grounds that in essence, both approaches are models of the quality of institutions, and therefore, the quality assessment itself can be to a certain degree inaccurate. At the same time, the study identifies two basic types of institutional change: those produced by the governing body (corrections) and those occurring spontaneously. A constraint on the rate of institutional change for economic growth is also obtained. In addition, the paper illustrates that the classical criteria for welfare assessment does not take into account the impact of these changes. This modifies the generally accepted approach in the field of welfare theory, turning the latter into an institutional theory. The final conclusion is that the policy of growth pursued in the conditions of changing institutions leads to even more unbalanced distribution of benefits between groups of economic agents, which imposes stricter requirements for institutional planning.
Keywords: institutional change; economic growth; rules; quality of rules; malfunction; welfare theory.
For citation: Sukharev O. S. (2023). Institutional change and the quality of rules in ensuring economic growth. Journal of New Economy, vol. 24, no. 1, pp. 6-25. DOI: 10.29141/2658-5081-2023-24-1-1. EDN: FEROML.
Article info: received August 3, 2022; received in revised form August 24, 2022; accepted September 9, 2022
Introduction
The founders of institutionalism explored various institutions and their impact on social development [Veblen, 2010], business transactions [Veblen, 2007; Commons, 2011], the interaction of agents and the influence of legal norms on economic decisions and contracts [Coase, 1993; Williamson, 1996; Ostrom, 2011], etc.
However, almost until the 1970s scholars did not give much attention to institutions' influence on economic growth. Some economists pointed to the importance of planning institutions and the need to organise them for economic development [Tinbergen, 1967], although they reduced the task of finding a socioeconomic optimum to a set of institutions that allow achieving the best state but not to the volume of consumption or production of goods. Accordingly, the production function, like the basic neoclassical models, could describe and explain a little if a set of institutions was determined exogenously and was considered unchanged, while it is updated rather quickly as it develops. Moreover, the rate of institutional change is increasing, which makes it necessary to consider their impact not only in the long term, as North does [1997], but also in the short term [Sukharev, 2011]. The fact that these changes became significant even over short time intervals could not but affect economic growth, its model description and economic policy formation [Sukharev, 2011].
Basic models of economic growth [Lucas, 2013] are built mainly on its factors' representation and assume equilibrium, for example, between investment and savings, aggregate demand and supply. At the same time, modern approaches note a fundamental difference in the development rates of their components [Spence, 2013]. Only at the end of the 20th century researchers began to modernise neoclassical models in some way, adding the influence of various institutions [Hodgson, 2003; Helpman, 2011], as well as to consider in detail the impact of institutional change on economic growth [Nelson, Winter, 2000; North, Davis, 2008]. At the same time, the issue of calculating institutions arose [North, Alston, Eggertsson, 1996; Makarov, 2003; Kleyner, 2004], i.e., of a quantitative assessment of their status and influence.
The costs of maintaining institutions are recognised as a determining parameter in the study of their impact on the agents' behaviour and changes in the economy [North, 1997, 2010; Eggertsson, 2001]. They influence institutional choice, contracting and technological shifts [Popov, 2015; Sukharev, 2017]. Their growth is possible with an increase in the number of institutions and various changes in the 'content of rules', which are not compensated by efficiency. This leads to 'social sclerosis' and a decline in economic growth.
Mansur Olson explained this outcome by an increase in the number of distributive coalitions and special interest groups [Olson, 2013], proving the existence of a stable statistical relationship between the given parameters using regression analysis
[Olson, 2013, pp. 132-153], although the latter one can also be regarded as a kind of consequence of institutions being formed in society that encourage this behaviour of groups1. However, Olson's theory also very limitedly explains the slowdown in economic growth by an increase in transaction costs due to an increase in the number of coalitions, since an rise in costs may be a reflection of economic growth. Its pace is slowing down, most likely due to the loss of efficiency, and not solely due to an increase in transaction costs. This growth may well be a consequence of the expansion of the corresponding sector of the economy and be justified by the results. If this does not happen and inefficiency rises, institutions are subjected to deep malfunction, then, certainly, a decline in growth and a recession in general is possible.
The foregoing suggests that the transactional mechanism is essential in describing the impact of institutional change on economic growth. It reflects the nature of institutional change. Wallis and North in 1986 singled out the transaction sector of the American economy in order not only to address the problem of measuring growth, but also to understand its structural patterns [Wallis, North, 1986].
All together, we can state that the approaches developed by institutionalism to studying the impact of institutions on economic growth are very ambiguous. It is due to the high complexity and heterogeneity of the object of research and it confirms the relevance of setting the relevant objectives. A strong influence is due to the quality of the rules, and the assessment of this quality causes a number of difficulties [Sukharev, 2011].
During the functioning of an institution like of a human body in the course of life, some disorders may arise and change due to various causes - malfunctions2. Such a biological analogy, being applied in economics, made it possible to develop a malfunction theory of institutions and systems that explains the specifics of economic changes and management [Sukharev, 2011, 2022]. This theory does not limit itself using such terms as "state interference" and "state non-interference", "market failures", due to ideas about the equilibrium functioning of the economy. In our opinion, these terms are no longer relevant in science today, since they do not make it possible to form an acceptable management idea of economic (institutional) change. Thus, the term "intervention" positions the situation under study and management as
1 According to the analysis presented by Olson, no separation of the factors influencing the growth rate, as well as their strict selection, was carried out. Institutional impact is mediated by various other factors, their current state. The rules cannot but affect the change in this state, but they themselves are dependent on changes of two basic types: 1) corrections carried out by the governing bodies; 2) spontaneous changes that have, along with external causes, internal, genetically determined. These issues have been studied within the framework of the new and old institu-tionalism, even by its modern representatives, very poorly. They constitute a very complex systemic perspective on the problem of studying institutional change.
2 Original contributions within the framework of the Russian theory of malfunctions, cf.: Sukharev O. S. (1999). Russian economy: Experience of system diagnostics and treatment. Investitsii v Rossii = Investments in Russia, no. 9, pp. 28-37. (In Russ.); Sukharev O. S. (2001). The theory of economic malfunction. Moscow: Machinostroenie Pabl. 212 p. (In Russ.)
something external to economic events, which is actually not the case, since the main generator of institutional change is the governing body, which permanently corrects the entire system of rules (formal institutions).
In line with the above, the main purpose of this study is to build a theoretical model of institutional change, according to which economic growth is presented as dependent on the quality and change rates of formal institutions.
Achieving this purpose will allow making relevant conclusions regarding the creation of the institutional theory of welfare, which, unlike the classical version, takes into account the impact of institutional change on the basic criteria of welfare (Pareto, Kaldor - Hicks, etc). The research methodology is based on the theories of institutional change, malfunctions and welfare. The methods of comparative and model analysis were used in the work.
The purpose involves accomplishing three main objectives:
• distinguishing between two main types of institutional change that ensure economic growth;
• considering malfunctions and quality of institutions as the most important interrelated parameters affecting economic growth;
• constructing the simplest model of institutional change; its description will make it possible to draw important conclusions about the welfare theory and economic growth management.
Two basic types of institutional change
Douglass North, one of the founders of the theory of institutional change, specified several propositions fundamental for this theory [North, 2010, pp. 122, 225, 237]:
• institutions are set up in order to reduce uncertainty;
• there are not any models taking into account all the specifics of economic growth and development, and therefore, there are no ready-made 'recipes' for economic policy;
• improving economic efficiency depends on a combination of formal and informal institutions, and this combination must be more or less accurately represented in order to ensure the desired result;
• efficiency of institutions is determined by the indicated combination [Ibid., p. 225] taking into account the special role of coercive rules;
• institutions ensure the stable development of economy by smoothing out the difference in relative prices [North, 1997, 2010].
Thus, the theory of institutional change formed by North described the long-term influence of institutions, closing the issue of the rules' efficiency on the rules themselves, as if removing agents from it1; outside their actions to comply with the rules,
1 Changes in relative value and people's preferences were interpreted as depending on relative price proportions.
the indicated efficiency does not make sense and does not exist. The institutional framework of the economy creates a certain sustainability of its development, ensures its growth, and the markets function effectively. In accordance with this logic, the violation of institutional stability should lead to serious shifts in development and crises. But what does the institutional stability mean when they change not only in the long term, but also in the short term, and these changes are happening faster and faster? In addition, the position that institutions reduce uncertainty or structure exchanges does not fully reflect the need to create new institutions. Moreover, this condition is not defining anymore, since the institutional corrections being made may pursue the goal of regulating agency relations and simply replacing the old institutions. They can increase, rather than decrease, the complexity of such contacts and the unpredictability of the outcome. At the very least, transaction costs may rise, but not fall. And, certainly, it is impossible to give an accurate idea of efficiency (according to the criterion of its classical definition) only in terms of costs, since for this it is necessary to compare costs with results, for example, consider the number of functions fully performed by an institution per unit of costs.
Formal institutions, unlike informal ones, are constantly changing, and there is a generator of such changes which is the legislative and executive power as a governing body. They are becoming tools for regulating economic development, provoking changes in institutions over short time intervals. Therefore, a long-term theory simply ignores the new reality. If in the past such institutions, including politics tools1, were relatively stable, today this is no longer the case. Moreover, depending on the ratio of transaction costs in formal and informal institutions, an agent's behaviour may change in a way when choosing which rule to follow.
This situation is shown in Figure 1. The abscissa shows the indicator of resource specificity K, the ordinate shows the indicator of institutional choice IC, which represents the ratio of transaction costs for formal and informal institutions. The bb line reflects the conditional dependence of the indicator of institutional choice on the specificity of the resources used. Depending on the resource type, according to Williamson's theory, the types of contracting are distinguished - classical, neoclassical and implicit [Williamson, 1996].
When the transaction costs of a formal rule are high and exceed the costs of an informal rule, agents will prefer informal relationships. Thus, to the left of point A in Figure 1 we have an implicit contracting (IC), which is associated with the use of a predominantly interspecific resource (IR). To the right of point A, the transaction
1 It should be noted that institutional impacts in the form of corrections by the government were not considered in detail in the form of economic policy tools. Institutional changes were presented as an understudied factor influencing economic growth.
Ic= TrF/TrN
b
b
IC IR
CC CR
K
Fig. 1. Institutional choice of an agent and types of resources according to Williamson
costs of a formal rule are lower than the transaction costs of an informal rule. Accordingly, it is beneficial for agents to comply with a formal rule - a classical contract (CC) and a common resource (CR) are applied. If transaction costs according to formal and informal rules are similar, so that the indicator of institutional choice is close to unity (IC = 1), then this is clearly a transitional state (interval Z) - a neoclassical contract (NC) and a specific resource (SR) are used [Sukharev, 2011, p. 179]. Transaction costs are considered here as a criterion for switching between types of contracting, but we should always consider that this can be just one, but a very strong one, of the possible criteria used by agents in a situation of institutional choice. By introducing rules or adjusting institutions, it is possible to influence the costs and other criteria for deciding which contract to use in a given situation.
Thus, introduced and changed rules are applied not only to streamline exchanges and reduce uncertainty, but to regulate relations and implement coercive influences on various groups of agents in order to develop their agreements and interactions in the direction necessary for a governing body. This generation of institutional change makes their first basic type, which can be referred to as institutional corrections1 [Sukharev, 2011, 2022]. The second basic type is classical - it is a spontaneous change of rules affected by other rules, due to genetic changes, when the internal content of a rule is transformed while interacting with agents, without the intervention of a governing body, or under the influence of informal relations and rules.
If the first basic type of institutional change extends its effect mainly to formal institutions (although there may be options for influencing traditions and customs), the second one covers both formal and informal rules.
1 Institutional corrections as a method of macromanagement are considered in detail in our work [Sukharev, 2022]. For the first time, a general description of institutional corrections is given in it, a taxonomy is carried out that makes it possible to distinguish their types, the concepts of slow and rapid adaptation to them (tafihilaxia) are introduced, the connection with efficiency and malfunction is studied by the introduced models of the functioning of an institution and the regimes of ongoing institutional corrections. Thus, a methodological foundation is created for the study of institutional corrections as a management tool and the condition of "institutional welfare" is formulated, as well as options for corrections in the "efficiency - malfunction" coordinates.
There are different types of institutional corrections depending on the nature of an observed change. Let us consider the most common ones:
1) change (partial replacement of a rule) of the content (quality) of an existing institution, which takes the form of replacing individual functions, properties or procedures, in the application of cost reduction;
2) complete replacement of an institution by an already existing or completely new rule with a different set of parameters (including import from the external environment);
3) addition - introducing additional rules, without changing or replacing an existing institution, in order to make such an introduction affect; the ability to follow the rule;
4) a growth in resource support for the operation of existing rules - a rise in monetary support (financing) for the functioning of institutions, revealing additional opportunities and increasing functions (reducing malfunction);
5) extension of an institution's functioning period (preservation of a rule); for example, in case of a refusal to comply with a rule, resuscitation is carried out by special decisions and the need to comply with it is confirmed.
In fact, these are not all correction options; the author of this article presents a detailed discussion of them in one of his works [Sukharev, 2022]. However, they represent the exact structure of options for institutional change, even regardless of whether institutional change belongs to the first or second type. The above distinction between these types emphasises the fundamental difference between spontaneous and intentionally implemented changes, but in the modern economic life they are strongly connected and determine each other. Both types embody a change in the quality of rules. Therefore, when finding out the quality of the institutional environment that promotes or inhibits its growth, this outcome is due to the cumulative effect of these types of changes. Moreover, the institutional corrections generated by a governing body can modify a situation in a great way, despite the fact that the quality parameter, especially in relation to a set of institutions, is a relative indicator.
Modern technologies give rise to completely new rules, for example, in the form of hybrid mechanisms that affect the organisation of transactions [Menard, 2018]. Attempts to overcome institutional complexity have led some analysts to create structures in the form of "intermediate institutions" or "meso-institutions" that influence socioeconomic interactions by creating the connection of basic rules. However, such approaches do not take into account rapid institutional change of the first type. As for the changes belonging to the second type, they are even harder to study. We note that the artificial introduction of additional structures often does not have a high analytical and scientific usefulness, since it further complicates the assessment of relationships according to such architecture. Moreover, there is a need to prove that there
is this particular architecture in life, although this is not always the case, because researchers create it using their imagination, not simplifying, but complicating the existing connections between rules and agents.
Some scholars have been able to find out, in particular, how individual rules can affect resource efficiency in rich and poor countries [Hartwell, 2016] or how imperfect contract enforcement due to the difference between current and future output affects economic growth [Aguirre, 2017]. There are publications considering the impact of the lock in effect on the overall efficiency and distortion of rational choice [Khalil, 2013]. A unified approach to the study of targeted institutional change in the form of corrections carried out by the government essentially comes down to revealing the influence of political institutions on the work of the government and making appropriate decisions [Bartolini, Santolini, 2017]. At the same time, the logic of applying an economic policy tool in the form of institutional corrections does not become an object of such an analysis.
However, along with the listed studies, which have a high localisation of the object and subject, there are attempts to develop a new theory of institutional change. In particular, Mahoney and Thelen declare the need to create a holistic theory of institutional change that satisfies the interests of various analytical groups - economists, sociologists and historians. They normatively introduce four ways to change an institution, depending on the parameters and political environment, i.e., a certain set of other institutions regulating the work of a country's political system. Such methods include displacement (cancellation of rules and introduction of new ones instead), layering (introduction of rules on top of or next to existing ones), drift (change of rules due to changes in the environment), conversion (change of rules due to strategic distribution) [Mahoney, Thelen, 2010].
As we can see, from the standpoint of taxonomy, our selection of five basic types of institutional change presented above includes individual cases of the Mahoney and Thelen classification. Further in this work, they pay a great attention to agents, attributing to them the main contribution to the generation of the considered changes, thereby striving to link the macro- and micro-levels of institutional analysis. The advantage of this work is that the researchers do not make artificial intermediate superstructures in the form of some 'meso-institutions'. An economic agent has two roles: it follows the rules and seeks to maintain or change them. In accordance with the types of institutional change, there are exactly four types of agents: those that provide displacement - fast or slow, drift, layering or conversion.
All described types of institutional change and agents' behaviour fit into both basic types of changes under consideration. However, this approach does not consider the generated institutional corrections as a method of implementing a policy of
institutional change and institutional design. At the same time, the role of a large number of economic agents is absolutized, the diversity of which is much wider than the described one by dividing into four groups. For example, with the phenomenon of institutional neutrality [Sukharev, 2011], there are probably many agents that do not affect changes in institutions in any way. At the same time, the role of the government as their generator can be dominant in the allocated time periods. Therefore, the first type of change will be stronger than the second one.
Changing institutions can raise or lower their quality, demonstrate a greater or lesser degree of disorder (malfunction) of their functions. This is becoming the main result of institutional change that has a clear impact on the economic and institutional efficiency (of the rules themselves). Let us consider this aspect in more detail, since it is the influence of the quality and degree of institutions' functional disorders on economic growth that has been hardly studied in the new institutional theory. Some useful results have been obtained within the modern Russian institutional school by developing the theory of malfunctions and describing approaches to measuring the quality of their functioning [Sukharev, 2011, 2017].
Malfunction and institutional quality
Malfunction of an institution (rule) is understood as a disorder of functions arising for various reasons, identified by the execution (non-performance) of a rule [Sukharev, 2011]. The concept of institutional quality is not as simple as it might seem at first, and it does not allow a direct analogy with product quality. The reason is that the agents cannot 'consume' a rule, they either follow it or do not follow it, and it performs a number of regulatory and other functions necessary for them. It is them that the agent follows or avoids following them. Therefore, the quality of an institution does not have a consumer dimension, although its assessment may well involve the selection of its parameters or characteristics, like the technical and economic parameters of products, with a further quantitative measure of their change for the same rule, but for different time intervals. One can then compare these parameters and draw a conclusion about whether the quality of an institution is changing. Moreover, how a rule is executed will be the most important parameter for assessing its quality. Apparently, low quality means non-execution of a rule, and high quality, on the contrary, allows us to say that it is being executed, i.e., its main function is being implemented.
The connection between the malfunction of a rule and its quality is non-linear, although it is hardly appropriate to discuss a high quality of an institution in case of a high disorder of functions, even if the agents execute a 'disordered rule'. Such a performance does not refer to what is necessary and why this rule was introduced, i.e., a high disorder of functions cannot in any way be associated with high quality.
Thus, the quality of rules can be assessed by their malfunction degree. The corresponding measuring framework was developed within the theory of malfunctions by the modern Russian economic school, as well as modeling the relationship between economic growth and malfunctions of the economic system [Sukharev, 2017, pp. 82-102]. The malfunction model in the process of adverse selection showed that economic growth can be accompanied by both an increase and a decrease in malfunctions [Sukharev, 2017, pp. 95-102]. Depending on the emerging growth, there are limits on the rate of institutional change. Therefore, how exactly the economy expands becomes important in growth policy, mainly in terms of functions, taking into account the asymmetry of information and the provision of resources for the functions performed. The expansion of functions cannot be carried out in the economy at will, not being connected with the reasonable possibilities and rate of this process. Therefore, the growth of welfare, at least in its functional part, depends on the initial institutional conditions and the rate of change in the rules. As it will be shown below, even the very criteria for assessing welfare are transformed under the influence of institutional change and depending on their quality. These moments are poorly taken into account both in the theory of economic growth and the theory of institutional changes, which options have been considered.
In addition to measuring malfunctions, a quality assessment method can be applied, reminiscent of its assessment in the economics of quality in terms of absolute, relative and integral indicators, when the parameters of a product, in this case an institution, are distinguished and compared. Only when it comes to products some items are compared with others, and as for institutional area, the state of this rule should be evaluated at different times. This, by the way, will be a kind of assessment of how a rule and its qualities are changed according to the distinguished characteristics. Identification of malfunction acts as a method of assessing quality, making up, in some way, the quality model of an institution. But the classical 'recipes' for assessing product quality1, applicable to institutions, only adjusted for comparing the state of the same institution at different times (since different institutions have different functions2), will also be a model way to represent the quality of this rule. These approaches are also applicable to a set of institutions - institutional environment. The sometimes-used aggregate method for assessing the quality of institutional environment is also nothing more than a quality measurement model. The accuracy of such a model depends on the aggregation, input parameters for assessing institutional environment, as well as a set of institutions that are included in the concept of "environment". Such
1 For example, according to the rate of use value - an indicator used in the economics of quality as subject, as well as in marketing.
2 In fact, the quality of products is also evaluated by one of their class, by competing products. It is impossible to compare the quality of a machine-building unit and bread or a watermelon.
an approach, as a rule, is even less accurate and useful than the above malfunction measures [Sukharev, 2011] and quality parameters of specific institutions.
The assessment of the quality of rules must be immediately carried out in time, which gives an idea of their change; moreover, it covers the genetic side of the degeneration of rules and institutional corrections, which also affect both the functions and quality of institutions.
Thus, the quality models of institutions can be presented as models of institutional change, or used to characterise or study them. We note that the relationship between quality and malfunction does not correspond to the nature of the relationship between efficiency and malfunction: a rule can show high malfunction, but with some positive performance. In one of our works, a model of such a relationship was built, which demonstrated that low and high efficiency of an institution can correspond to various levels of disorder in its functions, and these two parameters can change non-linearly, determining different modes of functioning1. It is especially significant to take into account these emerging regimes not only when modeling or describing economic growth, but also when shaping the policy of this growth.
For economic science, the connection between institutional change and the growth of the economic system is important. Institutional corrections can lead to different outcomes in terms of "efficiency - malfunction". In particular, efficiency and malfunction may decrease, or malfunction may increase and efficiency may decrease. The second option is more unfavourable than the first one. The best outcome is when efficiency increases and malfunction decreases. Such performance should be sought when carrying out institutional corrections.
Summarising the above, we will present the simplest model that allows us to reveal individual impact nuances of institutional change on growth, and we will reduce the analysis to the necessary change in the classical welfare criteria, considering these changes. Thus, a step will be taken towards the formation of the so-called institutional theory of welfare, which allows for changes in the distribution of benefits between agents under the influence of institutional corrections and other changes in rules.
Theoretical model of institutional change
To demonstrate, we will assume that the economy consists of two parts (or agents), and the benefit of each is determined by the amount of added value R1, R2, which in the general case grows at different rates depending on the ongoing institutional change (N). The indicator N is a characteristic of changes in institutions, reflecting their quality. The development of each part of the economy has a different sensitivity
1 For more details, cf.: Sukharev O. S. (2019). Economic theory of the evolution of institutions and technologies. Modeling problems in evolutionary theory and management. Moscow: Lenand Publ., pp. 302-304. (In Russ.)
to the change of institutions. The general welfare of such an economy is U = R1 + R2, i.e., it is determined by the total value added. A simplified version of the dynamics of this welfare is shown in Figure 2.
N* N
Fig. 2. Dependence of the economy's two agents (R1, R2) on institutional change (N)
Figure 2 shows that both parts of the economy are growing, but at different rates relative to institutional change. It is assumed that the parameters R1, R2 show the same sensitivity to these changes, determined by the angles a, which, according to Figure 2 do not change. Each part (agent) has its own sensitivity - the angles are different. In the long run, certainly, this sensitivity changes, but over a relatively short interval, it is quite possible to consider it as unchanged for each part (agent). Then it is obvious that R2 = f (R1). The relationship will be as follows: R2 = R1+ (N* - N) (tga - tg0). Since the slope angles do not change due to institutional change, we can denote: k(N) = (tga - tg0) = const. Let us write the following:
U = Ri + R2 = 2R1 + k (N* - N). (1)
Welfare growth requires compliance with the condition dU/dt > 0. Differentiating the expression (1) with respect to time, considering the equilibrium point to be unchanged, we have: 2dR1/dt - k dN/dt > 0.
Then we get:
(j)dR1
i mi/i ir > 11
(2)
dN
dt
dt
■, npM k > 0.
It follows from the expression (2) that the rate of institutional change dN/dt must be less than the weighted change in the underprivileged part of the economy (agent) R1 (up to N* point) in order for the economy to grow and welfare to increase. Taking into account dR1/dt > 0, we obtain: 0 < dN/dt < (2/k) dR1/dt.
Thus, a condition arises for limiting the rate of institutional change, which is a fundamental provision in the implementation of institutional reforms. It is usually motivated by an increase in the efficiency, rate and quality of economic growth, but
the speed of reform can greatly affect these noble goals of economic development. It is this circumstance that is usually not taken into account either in the institutional or general strategic planning.
Moreover, the higher the sensitivity of each part (agent) of the economy to institutional change, the more severe the restriction on the rate of their implementation is. They must be carried out more slowly in order for the economy to grow. This is especially important, since the parameter N also includes the quality of institutions, and its rapid change may not have a positive effect on economic development. The main problem remains - determining the acceptable rate in each specific situation, i.e., for a given economy. There is a great difficulty here, since until institutional change has taken place, it is very problematic to discuss their effectiveness, as well as quality, due to the incompleteness of the process. In a historical context, North studied institutional change that had already taken place [North, 1997], which is incomparably easier than studying changes that are ongoing and unfinished.
If we introduce the average per capita welfare g = U/P, where Р is the population size in a given economy, it is not difficult to show a constraint on the rate of institutional change similar to the expression (2). It is represented by the following expression:
Thus, in order for per capita welfare to increase, it is necessary to fulfill the constraint (3) on the rate of institutional change. Moreover, this rate, ceteris paribus, should be even less, since the weighted change in the population size is subtracted from the expression on the right in the constraint (2) (formula (3)).
The welfare of the economy (Figure 2) depends on institutional change, since the value added of both parts of the economy changes from N. Let us also assume that a =fl (N), P = f2(N) change depending on institutional change. Therefore, k = f(N), i.e., the sensitivity of the economy to institutional change, is a variable parameter. What is important is the welfare growth in the implementation of these change, i.e., dU/dN > 0. Considering that U = 2R1 + N*k - Nk, it is easy to obtain the following expression:
Formula (4), taking into account N* - N > 0, implies a condition for changing the sensitivity for economic growth, or for changing the benefits of the least wealthy part of the economy R1 (agent).
The greatest welfare of the economy is dU/dN = 0, from which it is easy to obtain the expression (5), i.e., the benefits of the least wealthy part of the economy (agent):
* AD*"" (f)dp
dt dt dt
(3)
dN = 2dRl j, (N* - N)dk
(4)
dR1 = 0,5 k(N) dN - 0,5 (N* - N) dk.
(5)
To ensure growth, the expression (5) takes the form of an inequality, where the change in benefit dR1 must exceed the right side of the expression (5). This is a condition for economic growth. Rewriting this expression, we see a constraint on changing the sensitivity of dk/dN to increase welfare.
Thus, the simplest calculations already confirm the complexity of studying and taking into account institutional change influencing this growth. However, it clearly follows from them that the rate of these changes, as well as the quality, certainly have a strong influence on economic dynamics, often becoming a prerequisite for its intensification or, conversely, slowdown.
In our previous work, a model of institutional change was considered using the case of the chess game "grandmaster - second-category chess player" with a demonstration of the adverse selection effect [Sukharev, 2011]. The scheme of this model is very similar to the scheme in Figure 2, but instead of R1 and R2, we consider ed not parts of the economy, but agents with different qualifications. The game itself assumed institutional change (of the rules), leading to the fact that it was allowed to move the pieces in a different way, but the number of pieces and the overall composition of the game did not change. In other words, the chess game remained a chess game. It was used as a demonstration basis for the realisation of the idea that institutional change could lead to the victory in the game of a second-category chess player, and not at all a grandmaster. This is consistent with the doctrine of negative selection, when the worst agents in the course of competition defeat the best ones. The economy can grow, but what happens to welfare is not clear, because it can decrease but not increase. In any case, the problem arises of reinterpreting the criteria for welfare, taking into account the impact of institutional change on welfare and its criteria. At the end of the present study, we briefly cover this important issue.
Towards the institutional theory of welfare
The classical criteria (Pareto, Kaldor - Hicks, Scitovsky) in welfare theory, which describe the distribution of income and resources, are static, i.e., they do not consider situations where not only the rules of economic behaviour that can affect the distribution of goods and incomes, but also the criteria themselves are changed, which are peculiar institutions. Let us again take the example of a chess game of two agents, when, precisely because of institutional corrections, a second-category chess player wins over an obviously stronger and more professional opponent - a grandmaster [Sukharev, 2011, pp. 156-174]. In economics, such outcomes are observed all the time, so the specified condition, when the best agents suffer an economic defeat, that is, lose benefits or do not experience growth, is of considerable analytical interest. Shown in Figure 2, the scheme for changing benefits may not be observed, since one
part of the economy can increase them, and the other can lose them. The same thing applies to agents, and a different dynamic emerges [Sukharev, 2011, p. 161] (Figure 3).
Fig. 3. Benefits of two agents (R1, R2) from institutional change (N)
However, at the same time the economy can show economic growth, within which the benefits are redistributed. The change in the agents' benefits within the game depends not only on the institutional corrections being made - their intensity and content (quality), but also on the sensitivity of agents to such changes - adaptation, as well as the accumulated knowledge and skills within the framework of the game in which they are involved, in particular chess1.
It is noteworthy that institutional corrections can be implemented in different ways in relation to chess. Firstly, before the start of a game, participants are notified of a change in the rules of a move or an attack on a piece. Thus, before a game, participants are aware of the change in its rules relative to those previously known to them. Secondly, rules change in the process, after a game has already begun. This last case imitates precisely the institutional corrections made in economic life in a permanent mode. The agents' reactions in this case are hardly predictable, as well as the overall result of their game. Benefits can either increase for both agents, or increase for one and decrease for another one, or decrease for all agents. The result changes in time depending on the set of conditions and the degree of agents' readiness, their characteristics. It is they who provide this or that perception of these institutional change, which can be generated both by the participants of a game itself by mutual agreement, and by external arbiters in relation to the players who do not participate in the game at a given time interval, but they are responsible for changing the rules in the process of its deployment.
1 The arguments that changing the rules of the game change the game itself are weak. If the number of pieces and the general chessboard foundation are maintained, and the corrections cover the order of moves or rules related to the use of pieces, how a pawn or knight moves, then this does not change the overall basis of the game. This is precisely what simulates a chess game in the process of institutional changes in the form of corrections. Thus, at least the first type of such changes is modeled, when the rules are changed intentionally for some purpose.
If in the course of changes the benefits of the two considered agents, as illustrated in Figure 2, grow, but the weakest of them (R1) demonstrates a higher rate of benefit growth, so that in the end both agents are compared in terms of benefits, it turns out that both agents improve their position permanently. The Pareto criterion is not met, because there is not any distribution, when one gets better, but the other one is necessarily worse. Up to the point of intersection of the lines in Figure 2, the Rawls criterion applies, since the welfare of the poor increases faster than the welfare of the rich, but to the right of this point, the previously poor become the rich, and the rich relative to them becomes the poor, although their welfare continues to grow (benefits increase). This maintains the Rawls principle, which states that the increase in welfare is tracked by the increase in benefits to the poorest part of society. In Figure 3, where the welfare growth of the agent R1 is obvious and the decrease in this growth for the agent R2, on the contrary, the Pareto criterion is revealed. One agent gets better, the other one gets worse.
In the case when the agents under consideration are not impersonal, and one of them is a grandmaster, for example, agent R2, and the other one is a second-category agent (R1), then it turns out that a change in the rules leads to an increase in the benefits of the second-category player and a decrease in the benefits of the grandmaster. This provokes the loss of the most prepared agent in such a game in the course of institutional change (N). The loss of a grandmaster's benefit is connected first with the deterioration of the position in the game, then with the draw occurring, and then with a possible loss (Figure 3). A victory for a second-category player is a situation to the right of point N*, when their benefits are greater than those of a grandmaster. If the benefits of players do not change when the rules change, then the effect of institutional neutrality arises. In this case, a grandmaster is supposed to win [Sukharev, 2011, pp. 163-164]. The welfare criteria under the influence of institutional change during the game (chess) and without it are compared in Table.
The malfunction of the rules that change during the game also will affect greatly the possibility of each agent's winning or losing. The situation becomes more complicated, and it is considered by the classical welfare theory, while the benefits and their distribution among agents change depending on the rules. Interestingly, classical new institutional theories such as the Coase theorem also do not pay attention to agents' functions and their change, which can transform and largely revise the formulation of the theorem1 itself.
The change in the welfare of agents and the economy consisting of them (Figure 3) depends on the benefits (income) of the least wealthy agent, the rate of change
1 This aspect is detailed in the following work: Sukharev O. S. (2020). Dysfunction of the rules and institutional effectiveness. Zhurnal ekonomicheskoy teorii = Russian Journal of Economic Theory, no. 2, pp. 433-450. (In Russ.)
Main welfare criteria under institutional change
Welfare criteria Standard content Criterion violation during institutional change (case of a chess game)
Rawls criterion Increase in the welfare of the weak (poor) improves society's welfare The victory of a weak one (a second-category player who improves their position*) in the game violates the status quo that has developed in institutions and does not increase the welfare of society, since a grandmaster loses in this case
Pareto criterion Someone gets better and no one gets worse If the benefit of one agent increases, and the benefit of the another one does not change or increases
Kaldor - Hicks criterion Compensation for the loss of the one who got worse in order to bring the situation to the Pareto criterion (in chess, in particular, through the allowance for the transition of a move) Compensation is impossible because the rules in chess do not allow the transition of a move**
Scitovsky criterion Ban on the reverse movement, to the previous situation (in chess, the prohibition on the transition of a move) If new rules allow the transition of a move, violating the Scitovsky criterion
Notes: * If this improvement occurs not due to the growth of knowledge and skills and the growth of the play level to a grandmaster or master of sports, but only because of a change in the rules of the game.
** Certainly, it is neglected that the participants in the game are paid a large fee even for losing. The analysis will change if such fees are provided. By the way, the very fact of the payout can be seen as an institutional change, because the classical chess rules do not provide for such payouts.
in welfare, and the nature of adaptation specified in Figure 3 slopes angles of the lines of change in each agent's benefits.
According to the Rawls criterion, the increase in the benefits of a second-category player, a weak agent, should be viewed as the main contribution to the rise in overall welfare. However, this does not work, since in the standard construction, social institutions should ensure the victory of the grandmaster. If they do not do this due to institutional change, it is they that give rise to a criterion contradiction. In fact, this means the practical adequacy of the Rawls criterion. There is not an increase in the welfare of society when a grandmaster loses, and a second-category player wins, especially if such cases are not isolated, but systemic.
However, in Figure 3, in contrast to Figure 2, the presence of the Pareto criterion is shown: one agent gets better, the other one gets worse. If there is institutional neutrality for at least one of the two agents, i.e., a change in the rules does not affect the benefit, then the Pareto criterion is not met. If the profit of one agent does not
change, but the profit of the second one decreases due to institutional change, such corrections should not be carried out or stopped, having neutralised the damage caused.
The Kaldor - Hicks criterion, which modifies the disadvantages of the Pareto criterion, in relation to the chess game mentioned above, considers the possibility of the transition of a move (provided there is not a fee for the game). Moreover, this may also be the result of an institutional modification of the game. The transition of a move is a kind of analogue of the compensation inherent in the Kaldor - Hicks criterion. Theoretically, the Scitovsky criterion should prohibit the transition of the move. If at the stage of planning a rule change, the state of Pareto efficiency is identified, i.e., in the case of initiating changes, one player becomes better in terms of benefits, and the other one gets worse, and then such changes, according to the classical Pareto criterion, should not be carried out. The difficulty is that at the beginning of changes, it is impossible to assess how exactly the benefits of agents will change, whether the correspondence will be with the curves shown in Figure 3 or in Figure 2, or there will be some other options. The different intellectual capital of agents leads to different perceptions of the rules and the ability to take advantage of new rules. However, there may be some corrections which ensure the victory of one agent over the other one, even if that other agent is more professional and perfect. This type of institutional competition in the evolutionary theory is described by the term hyper-selection (overselection), and among institutionalists by the term "adverse selection" [Sukharev, 2011].
The outcomes of institutional change are related to the fact that the classical welfare criteria of both Rawls and Pareto, and varieties of the latter criterion cease to describe the situation of the resources and benefits' distribution when changeable rules interfere in this process. This leads to the need to form a new institutional theory of welfare with the resulting innovations in the interpretation of economic growth and economic policy aimed at its stimulating.
Conclusion
Bringing the paper to a close, let us express the main propositions that we managed to identify and justify.
Firstly, institutional change has a powerful impact on welfare, but standard approaches to assessing its level do not take this impact into account.
Secondly, the measurement of malfunction acts as a method for assessing the quality of an institution, constituting a model measurement. However, other methods, including those transferred from the economics of quality, for instance, by the rate of value in use, also give only an approximate estimate, being a model approach.
Thirdly, based on the simplest model of institutional change we demonstrate that these changes affect the level of welfare, and there is a limit on the rate of rules changing, including a change in their qualitative state, which determines economic growth.
In addition, institutional change is not included in the standard criteria for assessing welfare, which do not always work in the case of institutional dynamics. Changing the rules often provokes adverse selection, decreasing rather than increasing welfare in the long run. Olson's explanation, being necessary, is not sufficient in such complicated cases, which was shown in our study [Olson, 2013]. The high rate of change in institutions, no matter what type of institutional change prevails, is likely to slow down economic growth. The rate of this growth is determined by the rate of population and income growth, especially for the poorest groups, advances in knowledge and technology, the sensitivity of agents to institutional change and the rate of the latter. This provides a limitation in the field of institutional and, accordingly, strategic development planning.
Thus, the impact of the institutional change and the quality of rules on economic growth and, more broadly, economic development seems to be a vast research area for modern scientists. The development of this area will yield great results and benefits for the economic science and, most importantly, the management of economic development.
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Information about the author
Oleg S. Sukharev, Dr. Sc. (Econ.), Prof., Chief Researcher. Institute of Economics of RAS, Moscow, Russia. E-mail: mail@osukharev.com
© Sukharev O. S., 2023
