13 Induced Institutional Innovation – Technological Change and the Environment

Chapter 13

Induced Institutional Innovation

Vernon W. Ruttan

13.1   Introduction

Technical change is increasingly generated by activities carried out in industrial research laboratories, agricultural experiment stations, and research universities—institutions that have become pervasive during the past century. Changes in resource endowments, cultural endowments, and technology have been an important source of institutional change. In attempting to understand institutional change, I employ a model that is similar to the model of induced technical change discussed in Chapter 2 of this volume. Institutional change, like technical change, is viewed as largely endogenous—as induced by changes in physical, social, and economic environments.1

The purpose of this chapter is not to understand how institutions evolve from a primitive institutional “state of nature.” Rather, it is to better understand how agents, acting individually and collectively, redesign existing institutions (such as land tenure or labor relations) or design new institutions (such as constructed markets to manage atmospheric pollution) that have a reasonable chance of success. Successful institutional design or redesign cannot simply be the product of the designers’ objective function or negotiations among interested groups and representative bodies. If institutional design or redesign is to be successful, it must respond to the changes occurring in the environment in which the institution will exist—such as increases in the price of labor relative to capital, or a rise in the relative value of open access or common property environmental resources or services relative to other factors.

In this chapter I elaborate a theory of institutional innovation in which shifts in the demand for institutional innovation are induced by changes in relative resource endowments and by technical change. The impact of advances in social science knowledge and of cultural endowments on the supply of institutional change are also considered. In a final section I discuss an important recent institutional innovation—the constructed market for sulfur dioxide (SO2) emissions.

Figure 13.1. Interrelationships between Changes in Resource Endowments, Cultural Endowments, Technology, and Institutions.

Source: Fusfeld (1980).

13.2   A Pattern Model

The elements of a model that maps the relationships among resource endowments, cultural endowments, technology, and institutions are presented in Figure 13.1.2 The model goes beyond the conventional general equilibrium model in which resource endowments, technologies, institutions, and culture (conventionally designated as tastes) are given.3 In the study of long-term social and economic change, the relationships among the several variables must be treated as dialectical or recursive. In my own work (with Hayami, Binswanger, and Thirtle), I have given major attention to the relationships among changes in resource endowments, technology, and institutions.

The changes in Japanese and US industrial technology and organization since World War II illustrate the dialectical or recursive interaction between technical and institutional change. The early postwar productivity gap in automobile assembly induced innovations in inventory control, assembly methods, and vehicle quality in Japan. These in turn induced the development of “lean production” in the US automobile industry. US innovations in information and communication technology led to institutional changes in the form of network-based coordination beyond the boundaries of the traditional firm. Japanese firms responded by adapting similar institutional arrangements in an attempt to overcome the US lead in high-technology sectors such as biotechnology (Aoki 1996:17).

The formal economic models that are employed to analyze the supply and demand for technical and institutional change can be thought of as being “nested” within the framework of Figure 13.1. One advantage of the “pattern model” outlined in Figure 13.1 is that it helps to identify areas of ignorance. Our capacity to model and test the relationships between resource endowments and technical change is relatively strong. Our capacity to model and test the relationships between cultural endowments and either technical or institutional change is relatively weak. A second advantage of the model is its usefulness in identifying the components that enter into other attempts to account for secular economic and social change. Failure to analyze historical change in a general equilibrium context tends to result in a unidimensional perspective on the relationships bearing on technical and institutional change.

For example, historians working within the Marxist tradition often tend to view technical change as dominating both institutional and cultural change. In his book Oriental Despotism (1957), Wittfogel (mistakenly) views the irrigation technology used in wet rice cultivation in East Asia as determining political organization. As it applies to Figure 13.1, his primary emphasis is on the impact of resources and technology on institutions (lines B and C). A serious misunderstanding can be observed in neo-Marxian critiques of agricultural developments associated with the “green revolution.” These criticisms have focused attention almost entirely on the impact of technical change on labor and land tenure relations. In terms of Figure 13.1, both the radical and populist critics have emphasized relation B, but they have tended to ignore relations A and C.4 This bias has led to repeated failure to identify the separate effects of population growth and technical change on the growth and distribution of income. The analytical power of the more complete induced innovation model is illustrated in this chapter in the work on the impact of both technical change and population growth on changes in land tenure and labor market relationships in the Philippines (see Section 13.3).

Alchian and Demsetz (1973) identify a primary function of property rights as a source of incentives to achieve greater internalization of externalities. They consider that the clear specification of property rights reduces transaction costs in the face of growing competition for the use of scarce resources. North and Thomas, building on the Alchian–Demsetz paradigm, have attempted to interpret the economic growth of Western Europe between 900 and 1700 primarily in terms of changes in property institutions (1970, 1973).5 During the eleventh and thirteenth centuries, the pressure of population against increasingly scarce land resources induced innovations in property rights that in turn created profitable opportunities for the generation and adoption of labor-intensive technical changes in agriculture. The population decline in the fourteenth and fifteenth centuries was viewed as a primary factor leading to the demise of feudalism and the rise of the nation-state (line C in Figure 13.1). These institutional changes in turn opened up new possibilities for economies of scale in nonagricultural production and in trade (line B).

Olson (1982) has emphasized the proliferation of institutions as a source of economic decline. He also regards broad-based encompassing organizations as having incentives to generate growth and redistribute incomes to their members with little excess burden. For example, a broadly based coalition that encompasses the majority of agricultural producers is likely to exert political pressure for growth-oriented policies that will enable its members to obtain a larger share of a larger national product. A smaller organization that represents the interests of the producers of a single commodity is more likely to pursue the interests of its members at the expense of the welfare of other producers and the general public. In contrast, an even more broadly based farmer–labor coalition would be more concerned with promoting economic growth than would an organization representing a single sector. But large groups, in Olson's view, are inherently unstable because rational individuals will not incur the costs of contributing to the realization of the large group program—they have strong incentives to act as free riders. As a result, organizational “space” in a stable society will be increasingly occupied by special interest “distributional coalitions.” These distributional coalitions make political life divisive. They slow the adoption of new technologies (line B) and limit the capacity to reallocate resources (line C). The effect is to slow economic growth or in some cases to initiate a period of economic decline (Olson 1982).6

The relationships in the lower left-hand corner of Figure 13.1 (dashed lines) have received relatively little attention from economists. An important exception is Greif's analysis of how the differential impact of the collectivist cultural endowments of Maghrebi traders and the individualistic cultural endowments of Genoese traders (line D) influenced the development of commercial institutions in the Mediterranean trading region in the eleventh and twelfth centuries (Greif 1994:912–950).

What are the implications of the theory of induced innovation for the research agenda on the economics of institutional change? It has been possible to significantly advance our knowledge about the rate and direction of technical change by treating it as endogenous—that is, induced primarily by changes in relative resource endowments and the growth of demand. A beginning has been made in developing a theory of induced institutional innovation in which institutional innovation is treated as endogenous. There is now a significant body of evidence suggesting that substantial new insights into institutional innovation and diffusion can be obtained by treating institutional change as an economic response to changes in resource endowments and technical change.

Changes in cultural endowments, including the factors that economists typically conceal under the rubric of tastes and that political scientists include under ideology, are important sources of both technical and institutional change. But our capacity to develop rigorous empirical tests capable of identifying the relative significance of the relationships between cultural endowments and the other elements of the model outlined in Figure 13.1 remains unsatisfactory. Until colleagues in the other social sciences provide more helpful analytical tools, economists will be forced to adhere to a strategy that focuses primarily on the interactions between resource endowments, technical change, and institutional change.

13.3   What Is Institutional Innovation?

Institutions are the social rules that facilitate coordination among people by helping them form expectations for dealing with each other. They reflect the conventions that have evolved in different societies regarding the behavior of individuals and groups. They include the internal routines and decision rules followed by firms and agencies to facilitate day-to-day operations or the practices espoused by religious organizations.7 In the area of economic relations they have a crucial role in establishing expectations about the rights to use resources in economic activities and about the partitioning of the income streams resulting from economic activity (Runge 1981, 1999; Schotter 1981:11; Nelson and Winter 1982:14–21).

To perform their essential role, institutions must be stable for an extended time period. But institutions, like technology, must also change if development is to occur. Anticipation of the latent gains to be realized by overcoming the disequilibria resulting from changes in factor endowments, product demand, and technical change is a powerful inducement to institutional innovation.8 Institutions that have been efficient in generating growth in the past may, over time, come to direct their efforts primarily to rent seeking to protect vested interests and thus become obstacles to further economic development.9 The growing disequilibria in resource allocation create opportunities for political entrepreneurs or leaders to organize collective action and bring about institutional changes.

This perspective on the sources of demand for institutional change bears some similarity to the traditional Marxian view.10 Marx considered technical change as the primary source of institutional change. The view expressed here is somewhat more complex in that it considers changes in factor endowments and product demand as equally important sources of institutional change. This definition of institutional change is not limited to the dramatic or revolutionary changes of the type anticipated by Marx. Rather, I share with Davis and North the view that basic institutions such as property rights and markets are more typically altered through the cumulation of incremental or evolutionary institutional changes such as modifications in contractual relations or shifts in the boundaries between market and nonmarket activities (Davis and North 1971:9). Very substantial shifts in the demand for institutional services may be required to overcome the transaction costs involved in negotiating changes in institutional arrangements and in overcoming resistance in implementing new institutional arrangements (Williamson 1985:15–42).

There is a supply dimension as well as a demand dimension to institutional change. Collective action leading to changes in the supply of institutional innovations often involves intense conflict among interest groups. Clearly, the process is much more complex than the two-class conflict between the property owners and the propertyless assumed by Marx. In this view, the supply of institutional innovations is strongly influenced by the cost of achieving social consensus. The cost of institutional innovation depends on the power structure of vested interest groups. It also depends critically on cultural traditions and ideologies, such as nationalism or religion, that make certain institutional arrangements more easily accepted than others.

Advances in knowledge in the social sciences (and in related professions such as law, management, planning, and social service) can shift the supply and hence reduce the cost of institutional innovation in a manner somewhat similar to the way that exogenous advances in the natural sciences reduce the cost of technical change. Advances in game theory have, during the past several decades, enabled economists and political scientists to bring an increasingly powerful set of tools to bear on their interpretation of institutional and technical change (Schotter 1981; Ostrom 1990; Aoki 1996). In spite of the power of these new tools, application of standard neoclassical microeconomic models involving shifts in the demand for and supply of institutional change remains exceedingly useful.11

Insistence that the processes of institutional innovation and diffusion can be understood by treating institutional change as endogenous to the economic system represents a clear departure from the tradition of modern analytical economics.12

This does not mean that it is necessary to abandon analytical economics. On the contrary, I try to expand the scope of modern analytical economics by treating institutional change as endogenous.

13.4   Demand for Institutional Innovation:
Property Rights and Market Institutions

In some cases the demand for institutional innovation can be satisfied by the development of new forms of property rights, more efficient market institutions, or evolutionary changes arising out of direct contracting by individuals at the community or firm level. In this section I draw on agricultural history for examples.

The English agricultural revolutions were associated with the enclosure of open fields and the replacement of a system in which small peasant cultivators held their land from manorial lords with one in which large farmers used hired labor to farm the land they leased from the landlords. The First Enclosure Movement, in the fifteenth and sixteenth centuries, resulted in the conversion of open arable fields and commons to private pasture in areas suitable for grazing. It was induced by expansion in the export demand for wool. The Second Enclosure Movement, in the eighteenth century, involved conversion of communally managed arable land into privately operated units. It is now generally agreed that this conversion was largely induced by the growing disequilibrium between the fixed institutional rent that landlords received under copyhold tenures (with lifetime contracts) and the higher economic rents expected from adoption of new technology, which became more profitable as a consequence of higher grain prices and lower wages. Enclosure was followed by substantial increases in land and labor productivity and by a redistribution of income from farmers to landowners, and the disequilibrium was reduced or eliminated.13

In another example, the opening up of nineteenth-century Thailand for international trade and the reduction in shipping rates to Europe resulted in a sharp increase in the demand for rice. The land available for rice production, which had been abundant, became more scarce. Investment in land development, primarily drainage and irrigation for rice production, became profitable. The response was a major transformation of property rights. In the half century after 1850, rights in human property (corvée and slavery) were largely replaced by more precise private property rights in land (Feeny 1982, 1988).14

The decollectivization of agriculture in China, beginning in 1979, provides a dramatic contemporary example of the impact of the transformation of property rights (Lin 1987, 1988; Fan 1991). The changes were induced by a productivity disequilibrium (in the range of 30 percent) between crop yields under the collective system and technology frontier yields. A transition to the household system was initiated spontaneously by peasant households, in spite of official sanctions, in a number of collectives in Sichuan province in 1978. By the early 1980s the transition had extended to other provinces and to small-scale industrial and commercial activities at the township level, and by the mid-1980s it had spread to broad sectors of the national economy. In the next section I discuss a recent case in the Philippines. The case is particularly interesting because it represents a carefully researched contemporary example of the interaction between technical and institutional changes in a Philippine village.

A case study of institutional innovation from the Philippines

Research conducted by Hayami and Kikuchi in a village in the Philippines, beginning in the late 1970s, has enabled us to examine in some detail a contemporary example of the interrelated effects of changes in resource endowments and technical change on the demand for institutional change in land tenure and labor relations (Hayami and Kikuchi 1982, 2000). The institutional innovations occurred as a result of private contracting among individuals. The study is unique in that it is based on a rigorous analysis of microeconomic data for a village in East Laguna over a period of several decades.

Changes in Technology and Resource Endowments

Between 1956 and 1976, rice production per hectare in the study village rose dramatically, from 2.5 to 6.7 metric tons per hectare per year. This increase resulted from two major technical innovations. In 1958, the national irrigation system, which permitted double-cropping to replace single-cropping, was extended to the village. And in the late 1960s, high-yielding rice varieties were introduced. The diffusion of modern varieties was accompanied by increased use of fertilizer and pesticides, and by the adoption of improved cultivation practices such as straight-row planting and intensive weeding.

Population growth in the village was rapid. Between 1966 and 1976 the number of households rose from 66 to 109 and the population rose from 383 to 464, while cultivated area remained virtually constant. The number of landless laborer households increased from 20 to 54. In 1976 half the households in the village had no land to cultivate. The average farm size declined from 2.3 to 2.0 hectares. The land was farmed primarily by tenants. Traditionally, share tenancy was the most common form of tenure. In both 1956 and 1966, 70 percent of the land was farmed under share tenure arrangements. In 1963, an agricultural land reform code was passed that was designed to break the political power of the traditional landed elite and to provide greater incentives to peasant producers of basic food crops. A major feature of the new legislation was an arrangement that permitted tenants to initiate a shift from share tenure to leasehold, with rent under the leasehold set at 25 percent of the average yield for the previous three years. Implementation of the code between the mid-1960s and the mid-1970s resulted in a decline in land farmed under share tenure to 30 percent.

Induced Institutional Innovation

The shift from share tenure to lease tenure was not, however, the only change in tenure relationships that occurred between 1966 and 1976. There was a sharp increase in the number of plots under subtenancy arrangements: from 1 in 1956 to 5 in 1966, and to 16 in 1976. Subtenancy represented a new institutional arrangement, rather than the diffusion of an existing institution, within the context of the village. The subtenancy arrangements were usually made without the formal consent of the landowner. The most common subtenancy arrangement was a fifty–fifty sharing of costs and output between subtenant and operator. Hayami and Kikuchi hypothesized that the incentive for the emergence of the subtenancy institution was disequilibrium between the rent paid to landlords under the lease-hold arrangement and the equilibrium rent—the level that would reflect both the higher yields of rice obtained with the new technology and the lower wage rates implied by the increase in population pressure against the land.

To test this hypothesis, market prices were used to compute the value of the unpaid factor inputs (family labor and capital) for different tenure arrangements during the 1976 wet season. The results indicate that the share-to-land was lowest and the operators’ surplus was highest for the land under leasehold tenancy. In contrast, the share-to-land was highest and no surplus was left for the operator who cultivated the land under the subtenancy arrangement (Table 13.1). Indeed, the share-to-land when the land was farmed under subtenancy was very close to the sum of the share-to-land plus the operators’ surplus under the other tenure arrangements. The results are consistent with the hypothesis. A substantial portion of the economic rent was captured by the leasehold tenants in the form of operators’ surplus. On the land farmed under a subtenancy arrangement, the rent was shared between the leaseholder and the landlord.

Table 13.1. Factor Shares of Rice Output per Hectare, 1976 Wet Season.

aPercentage shares are given in parentheses.
bSum of irrigation fee and paid and/or imputed rentals of carabao (water buffalo), tractor, and other machines.
cRents to sublessors in the case of pledged plots are imputed by applying the rate of 40 percent per crop season (a mode in the crop share distribution in the village).
Source: Hayami and Kikuchi (1981).

Table 13.2. Comparison between the Imputed Value of Harvesters’ Share and the Imputed Cost of Gamma Labor.

Based on employers’ data

Based on employees’ data

Number of working days of gamma labor (days/ha)a







Imputed cost of gamma labor (pesos/ha)b







(1) Total



Actual share of harvesters: In kind (kg/ha)c



(2) Imputed value (pesos/ha)d



(2) – (1)



aIncludes labor of family members who worked as gamma laborers.

bImputation using market wage rates (daily wage = 8.0 pesos for weeding, 11.0 pesos for harvesting).

cOne-sixth of output per hectare.

dImputation using market prices (1 kg rice = 1 peso).

Source: Hayami and Kikuchi (1981).

A second institutional change, induced by higher yields and the increase in population pressure, was the emergence of a new pattern of labor relationship between farm operators and landless workers. According to the traditional system called hunusan, laborers who participated in the harvesting and threshing activity received one-sixth of the harvest. By 1976, most of the farmers (83 percent) had adopted a new system called gamma, in which participation in the harvesting operation was limited to workers who had performed the weeding operation without receiving wages. The emergence of the gamma system can be interpreted as an institutional innovation induced by the disequilibrium between the institutionally determined wage rate and the market rate. In the 1950s, when the rice yield per hectare was low and labor was less abundant, the one-sixth share may have approximated an equilibrium wage level. With the higher yields and more abundant supply of labor, the one-sixth share became larger than the marginal product of labor in the harvesting operation.

To test the hypothesis that the gamma system permitted farm operators to equate the harvesters’ share of output to the marginal productivity of labor, imputed wage costs were compared with the actual harvesters’ shares (Table 13.2). The results indicate that a substantial gap existed between the imputed wage for the harvesters’ labor alone and the actual harvesters’ shares. This gap was eliminated if the imputed wages for harvesting and weeding labor were added. Those results are consistent with the hypothesis that the changes in institutional arrangements governing the use of production factors were induced when disequilibria between the marginal returns and the marginal costs of factor inputs occurred as a result of changes in factor endowments and technical change. Institutional change, therefore, was directed toward the establishment of a new equilibrium in factor markets.15

In the Philippine village case reviewed here, the induced innovation process leading to the establishment of equilibrium in factor markets occurred very rapidly, even though many of the transactions between landlords, tenants, and laborers were less than fully monetized. Informal contractual arrangements or agreements were used. The subleasing and gamma labor contract innovations evolved without the mobilization of substantial political activity or bureaucratic effort. Indeed, the subleasing arrangement evolved in spite of legal prohibition. The primary conclusion that I draw from the English enclosure movement, the Thai property rights case, and the Philippines subleasing case is that disequilibrium between institutional rents and economic rents are a powerful source of institutional change.

13.5   The Demand for Institutional Innovation:
Nonmarket Institutions and the Supply of
Public Goods

Changes such as those described in the previous section are profitable for society only if the costs involved in the assignment and protection of rights do not outweigh the gains from better resource allocation. If those costs are very high, it may be necessary to design nonmarket institutions in order to achieve more efficient resource allocation.16

In Japan, for example, although the system of private property rights was developed on cropland during the premodern period, communal ownership at the village level permitted open access to large areas of wildland and forestland, which were used for the collection of firewood, leaves, and wild grasses to fertilize rice fields. Over time, detailed common property rules evolved to govern the use of communal land so as to prevent resource exhaustion.17 Detailed stipulations of the time and place of use of communal land as well as rules for mobilizing village labor to maintain communal property (such as applying fire to regenerate pasture) were often enforced with religious taboos and rituals. Those communal village institutions remained viable because it was quite costly to demarcate and partition wildland and forestland and to enforce exclusive use.18 Group action to supply public goods, such as the maintenance of communal land or water resources, may work effectively if the group involved is small (Ostrom et al. 1999). If a large number of people are involved in the use of a public good, however, as in the case of marine fisheries, it is more difficult to respond to the demand for more effective resource management by means of voluntary agreements. Action by a higher authority with coercive power, such as government, may be required to limit free riding (Olson 1965).19

Agricultural research

The “socialization” of agricultural research has been common in market economies. New knowledge resulting from research is typically endowed with the attributes of a public good characterized by nonrivalness or jointness in supply and use, and nonexcludability or external economies.20 The first attribute implies that the good is equally available to all. The second implies that it is impossible for private producers to appropriate through market pricing the full social benefits arising directly from the production (and consumption) of the good—it is difficult to exclude from the use of the good those who do not pay for it. A socially optimal level of supply of such a good cannot be expected if its supply is left to private firms. Because present institutional arrangements are such that much information resulting from basic research is nonexcludable, it has been necessary to establish nonprofit institutions to advance basic scientific knowledge.21

A unique aspect of agricultural research in the past, particularly that directed to advancing biological technology, was that many of the products of research— even in the applied area—were characterized by nonexcludability. Protection by patent laws was either unavailable or inadequate. The nature of agricultural production made it difficult to restrict information about new technology or practices. Furthermore, even the largest farms were relatively small units and were not able to capture more than a small share of the gains from inventive activity. Private research activities in agriculture have been directed primarily toward developing mechanical technology for which patent protection is established.22

The public-good attributes of the research product together with the stochastic nature of the research production function have made public support of agricultural research socially desirable. It does not necessarily follow, however, that agricultural research should be conducted exclusively in government institutions financed by tax revenue. The social benefit produced by agricultural research can be measured as the sum of increases in consumers’ and producers’ surpluses resulting from the downward shift in the supply function of agricultural commodities. If the benefit consists primarily of producers’ surplus, agricultural research may be left to the self-organizing activities of agricultural producers (i.e., such institutions as agricultural commodity organizations and cooperatives). Research on a number of tropical export crops grown under plantation conditions, such as sugar, bananas, and rubber, is often organized in this manner.

During the past decade, extension of intellectual property rights institutions has induced a dramatic increase in private sector agricultural research. Even today, however, if agricultural research were left entirely to the private sector the result would be serious bias in the allocation of research resources. Resources would flow primarily to areas of technology that are adequately protected by plant variety registration, patents, or trade secrets (such as the inbred lines used in the production of hybrid corn seed). Other areas, such as research on open-pollinated seed varieties, biological control of insects and pathogens, and improvements in farming practices and management, would be neglected. The socialization of agricultural research or the predominance of public institutions in agricultural research, especially in the biological sciences, can be considered a major institutional innovation designed to respond to demand for more profitable technology that could not be embodied in proprietary products.

13.6   Social Science Knowledge and the Supply of
Institutional Innovation

The disequilibria in economic relationships associated with economic growth— such as technical change leading to the generation of new income streams—and changes in relative factor endowments have been identified as important sources of demand for institutional change. Institutional innovations are demanded because they enhance the welfare of rational actors. The issue of the supply of institutional innovations has largely been ignored in the economics literature. There is only a limited literature, for example, on how advances in economic knowledge or, more broadly, social science knowledge affect the supply of economic or social policy or institutions (Coleman 1990:61).

Throughout history, improvements in institutional performance have occurred primarily through the slow accumulation of successful precedents or as byproducts of expertise and experience. Institutional change was generated through the process of trial and error, much in the same manner that technical change was generated before the invention of the research university, the agricultural experiment station, or the industrial research laboratory. The institutionalization of research in the social sciences and related professions has opened up the possibility that institutional innovation can proceed much more efficiently, that it will be increasingly possible to substitute social science knowledge and analytical skill for the more expensive process of learning by trial and error.23

The research that advanced our understanding of the production and consumption of rural households in less developed countries demonstrates how advances in knowledge increase the supply of more efficient institutions (Schultz 1964; Nerlove 1974). In a number of countries this research has led to the abandonment of policies that viewed peasant households as unresponsive to economic incentives. It has also led both to the design of policies and institutions that make more productive technologies available to peasant producers, and to the design of more efficient price policies for factors and products.

In the examples of the demand for institutional innovation discussed in the previous sections, there has been little attempt to consider the interaction between the supply of and demand for institutional innovation. There is, however, a modest literature that has employed the “political market” metaphor to discuss the market for votes within legislative bodies, the market for the distribution of wealth among constituencies, and exchanges between legislators and bureaucrats and constituencies and interest groups (Keohane et al. 1998). In the next section, I present a case study of how shifts in both supply of and demand for SO2 pollution control led to the design of a “constructed market” for tradable air pollution permits in the United States. Constituents and environmental interest groups were the source of the increase in demand for the regulation of SO2 emissions. Advances in economic knowledge led to an understanding of the very large cost reductions that could be achieved by utilizing a “constructed market” rather than traditional “command-and-control” methods to reduce SO2 emissions. Resource economists, the federal bureaucracy, and the US Congress responded by supplying a constructed market in tradable emission permits.

Models that have been widely employed in recent institutional analysis— such as the tragedy of the commons, the logic of collective action, the prisoner's dilemma game, and mechanism design—are profoundly pessimistic about the ability of individuals, acting alone or in cooperation, to achieve common action. The problem of optimal institutional design has not been solved, even at the most abstract theoretical level (Hurwicz 1972, 1998). Producers or consumers, or both, will have an incentive to deviate from the formal rules of the allocation mechanism (a failure of “incentive compatibility”); and they will be able to do so by misrepresenting facts about which (thanks to “information decentralization”) they have unique, privileged information (producers about their production functions, consumers about the preferences) (Goodin 1996:32). The research on institutional innovation by Ruttan and Hayami (1984), Ostrom (1990, 2000), and Keohane et al. (1998) is much more optimistic. But one can be optimistic only if the objective is to design better rather than optimal institutions. In the next section, I discuss an important recent example of the role of advances in economic knowledge in the design of an institutional innovation. Economics as a discipline came into being and developed during an era of natural markets. It has lagged in its understanding of the behavior and implications of constructed markets.24

13.7   Emissions Trading

One of the clear implications of the previous discussion is that continued access to the material sources of production and reduction of the environmental impacts of economic activity will require the design of incentive-compatible institutions. The theory of induced institutional innovation does not assume that these innovations will occur as a simple response to the “invisible hand” of the market. It does assume that changes in both relative prices, as expressed in economic markets, and in the values placed on public goods, as expressed through political markets, will induce institutional change. If market prices do not accurately reflect relative scarcities, the resulting disequilibrium will generate substantial institutional rents, which will, in turn, induce both technical and institutional change.

In this section I discuss the emergence of emissions trading as an example of a public sector institutional innovation—a “constructed market”—induced by the rising economic value of formerly open access resources.25 The development of constructed markets for emissions trading was one of the most successful institutional innovations in the field of environmental management in the 1980s and 1990s. The concept is relatively simple. It is based on the realization that the behavioral sources of the pollution problem can be traced, to a substantial degree, to poorly defined property rights in environmental resources such as air and water.

The appeal of market-based systems to manage air pollution can be understood to a substantial degree in terms of the deficiencies of the “command-and-control” regulatory system established after the passage of the 1970 Clean Air Act in the United States. The objective of that act was to “protect and enhance the quality of the nation's air.” In response to it, the US Environmental Protection Agency (EPA) defined air quality standards to be implemented by the individual states. Emission standards were established for each emitter based on what could be achieved by the use of “best practice,” or best available technology.26 Any emissions above these standards placed the emitter in noncompliance, making it subject to sanctions. In principle, the Clean Air Act regulatory approach involved the specification of emission standards or legal ceilings on all major emission sources at specific emission points—stacks, vents, storage tanks, etc.27

A system of property rights and tradable permits for the management of pollution was first proposed in the late 1960s (Crocker 1966; Dales 1968a, 1968b). This institutional innovation did not emerge from its inventors in a fully operational form. The early proposals were followed by a large theoretical and empirical literature (Bohm 1985). Implementation has involved an extended process of “learning by doing” and “learning by using.”

Proposals by President Lyndon B. Johnson for effluent fees and by President Richard M. Nixon for a tax on lead in gasoline had been dismissed as impractical and characterized by environmental activists as a “license to pollute.” Beginning in the mid-1980s, however, a series of events conspired to make a more market-oriented approach to reducing SO2 emissions politically feasible (Taylor 1989:28–34; Hahn and Stavins 1991; Stavins 1998). One was President George Bush's predilection for a market-oriented approach to environmental policy. Another was the enthusiasm of EPA administrator William K. Reilly and a number of key staff members in the Executive Office for validating President Bush's desire to be known as “the environmental president.” Congress also provided high-profile, bipartisan support for a variety of market-based approaches, including SO2 allowance trading.

Within the environmental community, the Environmental Defense Fund (EDF) began to support market-based approaches as early as the mid-1980s. In 1989, the EDF worked closely with the White House staff in drafting an early version of proposed legislation. The credibility of the effort was enhanced by the fact that EPA Administrator Reilly, formerly president of The Conservation Foundation, was a “card-carrying” environmentalist. The business community displayed a curious ambiguity toward the emissions trading proposal. Executives of several major corporations, influenced by subtle lobbying by the EDF, commented favorably on the emissions trading proposal. At the same time, lobbyists representing several major business associations opposed the proposed reforms.

The design of the SO2 emissions trading system under the 1990 amendment to the Clean Air Act drew on earlier EPA experience. The EPA began experimenting with emissions trading permits in 1974. The early programs included the elimination of lead in gasoline, the phaseout of chlorofluorocarbons and halons in refrigeration, and the reduction of water pollution from nonpoint sources. The early programs had a mixed record. They were typically grafted to existing command-and-control programs. The difficulty of converting from command-and-control requirements to tradable emission programs encountered substantial transaction costs. These experiences did, however, provide important lessons for the development of more market-oriented trading programs in the 1990s.

The Clean Air Act created a national market for SO2 allowances for coal-burning electrical utilities. The commodity exchanged in the SO2 emissions trading program is a property right to emit SO2 that was created by the EPA and allocated to individual firms. A firm can make the allowances issued to it available to be traded to other firms by reducing its own emissions of the pollutant below the baseline level.

In 1995, the first year of the program, 110 of the nation's dirtiest coal-burning plants were included. The affected plants were allowed to emit 2.5 pounds of SO2 for each million British thermal units (Btu) of energy that they generated. During Phase II, which began in 2000, almost all coal-burning electric power plants will be included and allowances for each plant will be reduced to 1.2 pounds per million Btu. Utilities that “overcomply” by reducing their emissions more than required may sell their excess allowances. Utilities that find it more difficult, or expensive, to meet the requirement may purchase allowances from other utilities.

The evidence available suggests that emissions trading has been even more cost-effective than initially anticipated. Prior to initiation of the program, the utility industry had complained that reducing SO2 in amounts sufficient to meet the projected target (8.95 million tons in 2000, down from about 19 million tons in 1980) might cost as much as US$1,500 per ton. By the mid-1990s allowances were being sold in the US$100–125 range. The decline in the cost of abatement has been due in part to technical changes in coal mining and deregulation of rail transport that have lowered the cost of low-sulfur coal. It has also been due to technical changes in fuel blending and SO2 scrubbing technology induced by the introduction of performance-based allowance trading. Benefits have exceeded early estimates (Joskow et al. 1998).

As of the late 1990s, other emissions trading programs were being implemented. One of the most ambitious is the RECLAIM program developed by the South Coast Air Quality Management District in the Los Angeles area. Emitters of sulfur and nitrogen oxides have been issued annual allowances that decline each year. Any new emission sources must be accommodated within the cap by acquiring allowances from existing emitters. Some oil refiners have met part of their obligations by purchasing and destroying automobiles made before 1971. In 1998, a group of 12 northeastern states were considering an emissions trading system for reducing ozone levels. The Chicago Board of Trade was exploring the possibility of a futures market in carbon dioxide emission certificates (Fialka 1997). In the spring of 1998, the EPA proposed an emissions trading program, modeled on the SO2 program, to reduce emissions of nitrous oxides. The successful experience with SO2 emissions trading illustrates a very important principle in inventing new property rights institutions to manage access to formerly open access resources. In a now classic paper, Coase (1960) argued that when only a few decision makers are involved in the generation of externalities and only a few consumers are affected by the externality, the two parties, if left to themselves, will voluntarily negotiate a set of payments (or bribes) that result in a reduction of the externalities to an acceptable level. However important analytically, the Coase theorem has little relevance to most externality problems. The important externality problems that concern society today, such as SO2 pollution, typically involve large numbers of polluters and even larger numbers of persons affected by the externalities. Direct negotiation would involve unacceptably large transaction costs.

In 1968 Dales argued that “there exists no economically optimum division between amenity and pollution uses of water” (1968a:799). Regardless of political or economic considerations, the decision must be arbitrary. An implication is that, in contrast to a “natural” market, the government must make the decision in order to establish the conditions necessary for a “constructed” market to function (Coggins and Ruttan 1999). In the SO2 case it was necessary for an outside principle, the US Congress, to define the size (or the boundaries) of the private resource, in this case the maximum tons of SO2 emissions, and to establish trading rules. In the absence of public intervention there would have been no private market in emissions.

13.8   Perspective

In my research the theory of induced innovation has been used as a primary organizing concept for interpreting historical processes leading to changes in the rate and direction of technical and institutional change. This does not mean that I insist that either the rate or direction of technical or institutional change is entirely endogenous. There is an autonomous or exogenous element in advances in knowledge and in technical and institutional changes. I do insist, however, that changes in relative factor endowments, interpreted through both market and nonmarket institutions, have altered the rate and direction of both technical and institution change.

Three of these changes in relative resource endowments have represented exceedingly powerful driving forces in inducing both technical and institutional change:

•  The closing of the land frontier has been a major driving force inducing both technical and institutional change in agriculture in both traditional and modern societies.

•  Increases in the price of labor relative to capital have been a pervasive force of technical and institutional change in both industry and agriculture for at least the past two centuries.

•  During the last quarter of the twentieth century, the rising value of open access and common property environmental resources became an important driving force in inducing institutional change.

The world is well on its way toward a transition that will lead to a closing of its remaining commons—in establishing more carefully defined property rights in its remaining open access and common property resources. This institutional change will, in turn, have a profound impact on both the rate and direction of technical change.


This paper was originally presented at a conference on Induced Technology Change and the Environment, held at the International Institute for Applied Systems Analysis, Laxenburg, Austria, on 21–22 June 1999. I draw heavily on Ruttan (1978, 1997) and on my earlier work with Yujiro Hayami. See, in particular, Ruttan and Hayami (1984), and Hayami and Ruttan (1985). For a very useful review, see Lin and Nugent (1995). Runge (1999) has traced the evolution of thought from induced technical to induced institutional change. I am indebted to Robert E. Evenson for comments on an earlier draft of this paper.


1.   Schotter (1981:3–4) notes that in economics there have historically been two distinct interpretations of the rise of social institutions—“collectivist” and “organic.” He identifies the collectivist view with the work of Commons and the organic view with that of Menger and Hayek. What Schotter terms the organic view is similar to the endogenous or induced innovation view employed in this paper. What he terms the collectivist view is similar to what Hurwicz (1972, 1998) terms the “designer” perspective. I employ a design perspective, informed by an induced innovation perspective, in my discussion of institution design and redesign. Thus, I reject the need to choose among these two perspectives. They are complementary rather than competitive. Further, the objective of the approach that I employ is not to “liberate” economics from its fixation on the market (Schotter 1981:1). Rather, my objective is to apply the tools of neoclassical microeconomics to the analysis and design of institutional change.

2.   Fusfeld uses the terms pattern model or gestalt model to describe a form of analysis that links the elements of a general pattern together by logical connections. The recursive multicausal relationships of the pattern model imply that the model is always “open”—“it can never include all of the relevant variables and relationships necessary for a full understanding of the phenomena under investigation” (Fusfeld 1980:33). Ostrom (1990) uses the term framework rather than pattern model: “The framework for analyzing problems of institutional choice illustrates the complex configuration of variables when individuals . . . attempt to fashion rules to improve their individual and joint outcomes. The reason for presenting this complex array of variables as a framework rather than a model is precisely because one cannot encompass the degree of complexity within a single model.” (Ostrom 1990:214)

3.   In economics, the concept of cultural endowments is usually subsumed under the concept of tastes, which are regarded as given, that is, not subject to economic analysis (Stigler and Becker 1977). I use the term cultural endowments to capture those dimensions of culture that have been transmitted from the past. Contemporary changes in resource endowments, technology, and institutions can be expected to result in changes in cultural endowments (Ruttan 1988).

4.   A major limitation of the Marxian model is the emphatic rejection of a causal link between demographic change and technical and institutional change (North 1981:60, 61). This blindness to the role of demographic factors, and to the impact of relative resource endowments, originated in the debates between Marx and Malthus. An attempt to correct this deficiency represents a major innovation of the “cultural materialism” school of anthropology (Harris 1979).

5.   For a critical perspective on the North–Thomas model, see Field (1981:174–198). Field is critical of the attempt by North and Thomas to treat institutional change as endogenous.

6.   For a critical review of Olson's work, see North (1983:163, 164).

7.   There is considerable disagreement regarding the meaning of the term institution. A distinction is often made between the concepts of institution and organization. The broad view, which includes both concepts, is most useful for our purpose and is consistent with the view expressed by both Commons (1950:24) and Knight (1952:5). This definition also encompasses the classification employed by Davis and North (1971:8, 9). The more inclusive definition is employed to allow consideration of changes in the rules or conventions that govern behavior within economic units, such as families, firms, and bureaucracies; among economic units, as in the case of the rules that govern market relationships; and between economic units and their environment, as in the case of the relationship between a firm and a regulatory agency. Thus, organizations are defined as a subset of institutions involving deliberate coordination (Vanberg 1994).

8.   See North and Thomas (1970, 1973) and Schultz (1975).

9.   The role of special interest “distributional coalitions” in slowing society's capacity to adopt new technology and reallocate resources in response to changing conditions is a central theme in Olson (1965, 1982) and in the rent-seeking literature (Krueger 1974; Tollison 1982).

10.  “At a certain stage of their development, the material forces of production in society come in conflict with the existing relations of production, or—what is but a legal expression for the same thing—with the property relations within which they had been at work before. From forms of development of the forces of production these relations turn into their fetters. Then comes the period of social revolution. With the change of the economic foundation the entire immense superstructure is more or less rapidly transformed” (Marx 1913:11–12). For a discussion of the role of technology in Marxian thought, see Rosenberg (1982:34–51).

11.  The microeconomic approach to understanding the process of institutional change is similar to that employed by Becker in analyzing institutions such as the family (Becker 1991, 1993). A major difference is that I focus on the changes in the environment, such as changes in relative factor and product prices, that are exogenous to the institution being studied and that induce institutional change over time.

12.  The orthodox view was expressed by Samuelson (1948): “The auxiliary [institutional] constraints imposed upon the variables are not themselves the proper subject of welfare economics but must be taken as given” (221–222). Contrast this with the more recent statement by Schotter: “We view welfare economics as a study . . . that ranks the system of rules which dictate social behavior” (1981:6). There are now five fairly well-defined “political economy” traditions that have attempted to break out of the constraints imposed by traditional welfare economics and treat institutional change as endogenous. These include the theory of property rights, the theory of economic regulation, the theory of rent-seeking interest groups, the liberal-pluralist theories of government, and the neo-Marxian theories of the state. In the property rights theory, government plays a relatively passive role; the economic theory of regulation focuses on the electoral process; the rent-seeking and liberal-pluralist theories concentrate on both electoral and bureaucratic choice processes; and the theory of the state attempts to incorporate electoral, legislative, and bureaucratic choice processes. For a review and criticism, see Rausser et al. (1982).

13.  There has been continuing debate among students of English agricultural history about whether the increases in rents that landowners received after enclosure were because enclosed farming was more efficient than open-field farming or because enclosures redistributed income from farmers to landowners. See Chambers and Mingay (1966), Dahlman (1980), Allen (1982), and Overton (1996).

14.  For a similar interpretation of the evolution of property rights in pre-colonial Hawaii, see Roumasset and La Croix (1988).

15.  A second round of technical and institutional changes occurred in the 1990s. Nonfarm employment opportunities expanded as a result of better transport to the metropolitan Manila area and the location of a small metal craft industry in the village; wage rates rose and threshing by small portable threshing machines largely replaced manual threshing. The labor share for harvesting declined and a new form of labor contract, referred to as new hunusan, emerged. As a result of nonfarm employment, incomes of former farm labor households have risen (Hayami and Kikuchi 2000).

16.  Demsetz has pointed out that the relative costs of using market and political institutions are rarely given explicit consideration in the literature on market failure. An appropriate way of interpreting the “public goods” versus “private goods” issue is to ask whether the costs of providing a market are too high relative to the cost of nonmarket alternatives (Demsetz 1964). A similar point is made by Hurwicz (1972).

17.  For an explanation of the distinction between open access and common property, see Ciriacy-Wantrup and Bishop (1975). In the case of open access, use rights have not been fully established. In the case of common property, rules have been established that govern joint use. Common property is therefore a form of land use that lies between the extremes of open access and fully exclusive private rights. The problem of resource exhaustion in open access properties is elaborated in Demsetz (1967) and Alchian and Demsetz (1973).

18.  The term public economies has been suggested to describe the economic behavior of institutions “that provide services by arranging for the production, regulation, access, patterns of use, and appropriation of collective good” (Ostrom, 1998:6–7).

19.  Several students of institutional change have emphasized that coordinated or common expectations, resulting from the assurance provided by traditional institutions or common assumptions about equity or ideology, have permitted much larger groups to engage in either implicit or explicit voluntary cooperation than is implied by Olson's model (see Runge 1981:595–606). North notes that “the premium necessary to induce people to become free riders is positively correlated with the perceived legitimacy of the existing institution” (1981:54).

20.  For a characterization of the nonrivalness and nonexcludability attributes of public goods, see Samuelson (1954, 1955, 1958) and Musgrave (1959). Nonrivalness is an essential attribute of information. The use of information about a new farming practice (e.g., contour plowing) by a farmer is not hindered by the adoption of the same practice by other farmers. Nonexcludability, in contrast, is not a natural attribute of information but rather is determined by institutional arrangements. In fact, patent laws are an institutional arrangement that makes a certain form of information (called an “invention”) excludable, thereby creating profit incentives for private creative activities. Retention of trade secrets is another legally sanctioned method of retaining control over inventions or other forms of new technical knowledge.

21.  For a history of the establishment of public sector agricultural research systems in a number of developed and developing countries, see Ruttan (1983).

22.  In a number of countries, “breeders’ rights” and “petty patent” legislation have induced rapid growth in private sector agricultural R&D (Ruttan 1982; Evenson and Evenson 1983). Advances in biotechnology have been associated with rapid extension of intellectual property rights (Ruttan 2001).

23.  For a review of the role of social science research in social policy, see Coleman (1990:610–649).

24.  For further discussion of the distinction between natural markets and constructed markets, see Coggins and Ruttan (1999).

25.  This case is discussed in greater detail in Ruttan (2001).

26.  The 1970 Clean Air Act recognized two main types of air pollutants. Criteria pollutants are relatively ubiquitous substances. They included sulfur dioxide, suspended particulates, carbon monoxide, nitrogen oxides, hydrocarbons, ozone, and lead. “Criteria documents” that summarized the existing research on the health and environmental effects associated with these pollutants were required as a step in the formulation of emission standards. Hazardous pollutants included a number of airborne substances, particularly heavy metals, that had been implicated in cancer or showed other serious health effects. The act required the EPA to list and regulate any pollutants that fit this description. These included asbestos, beryllium, mercury, vinyl chloride, benzene, radionuclides, and arsenic (Tietenberg 1985:2, 3).

27.  Stavins (1998) points out that, while there are several alternative market-based instruments available, US experience has been dominated by grandfathered trading permits in spite of the fiscal advantages to the government of emissions taxes or auctioned permits. One explanation is that both environmental advocates and politicians have a strong incentive to avoid policy instruments that make the costs of environmental protection highly visible to consumers and voters. A second is that industry prefers grandfathered permits because they minimize the cost of compliance for existing firms (Keohane et al. 1998).


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