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Modeling institutional change in transition economies
Communist and Post-Communist Studies 38 (2005) 109e120 www.elsevier.com/locate/postcomstud
Modeling institutional change in transition economies Nicholas C. Kyriazis*, Michel S. Zouboulakis Department of Economics, University of Thessaly, Argonauton Str. 38221 Volos, Greece
Abstract A particular aspect of path dependence and change is discussed here. To understand institutional change in transition economies, a game theoretic model that combines economic changes with changes in the social values system is proposed, in a mechanism where the two changes are interdependent and influence one another in a repeated game. The speed of change in this dynamic model is the result of two rates, the ‘‘learning rate’’, how fast agents are learning to play the new ‘‘capitalist’’ game and the so-called ‘‘going-over rate’’, the mix in every time period of economic agents playing according to the ‘‘old’’ communist values and those playing according to the ‘‘new’’ capitalist values. Ó 2005 The Regents of the University of California. Published by Elsevier Ltd. All rights reserved. Keywords: Transition economies; Game theory; Path dependence and change
Lock-in and social change The idea of path dependence has raised considerable interest in its various aspects. A path dependent process of economic evolution is defined as one in which ‘‘important influences upon the eventual outcome can be exerted by temporarily
* Corresponding author. Tel.: C30 24210 74882; fax: C30 24210 74772. E-mail address: [email protected] (M.S. Zouboulakis). 0967-067X/$ - see front matter Ó 2005 The Regents of the University of California. Published by Elsevier Ltd. All rights reserved. doi:10.1016/j.postcomstud.2005.01.004
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remote events, including happenings dominated by chance elements rather than systematic forces’’ (David, 1985). This process is characterized by inertia, once an outcome begins to stabilize, it becomes progressively locked to attractors not always optimal, and by ‘‘non-ergodicity’’ in that historical ‘‘small events’’ are not averaged away and ‘‘forgotten’’ by the dynamics of the evolution of the economy (Arthur, 1989). David (2002, p. 19) offers a definition which can be helpful for the sake of our analysis: ‘‘a path dependent stochastic process is one which asymptotic distribution evolves as a consequence (function) of the process’s own history’’. Economists have distinguished at least three different areas of lock-in: a) Technological: Attempting to explain the possible trapping in inferior technologies (Arthur, 1989; David, 1985, 1994). Thus, Nelson and Winter (1982, p. 237) have explained technological lock-in: ‘‘It is time consuming and costly for a firm to learn about, and learn to use technology significantly different from that with which it is familiar’’. The cost of introducing new technologies may be perceived by some firms as being higher than what it actually is.1 Still, they further elaborate this idea to suggest the ‘‘neighborhood’’ concept e successful choices made today can guide and prepare those that will be made tomorrow. The result of today’s research, besides offering a successful new technology, can become a natural starting point for tomorrow’s research. Consequently, technology becomes ‘‘cumulative’’. b) Institutional: Examining why national economies can be stuck with inefficient institutions that inhibit growth (North, 1981, 1990; Hodgson, 1999, 2001). Or, more generally, how electoral rules and political regimes shape economic policy (Persson, 2002). Relatively to institutional lock-in, a growing number of scholars try to explain the slowness of transition of former communist countries to market economies by focusing on the institutional framework, both formal and informal,2 inherited by the old communist regimes that is very slow to adapt and change. (Rizopoulos, 1999; Pejovich, 2002; Zouboulakis, 2002). c) Spatial: Concerning firm location and its impact on regional development (Krugman, 1991; Fotopoulos and Spence, 1999). Similarly, Gilpin (2002) uses the concept of path dependence in order to explain competitive advantages of different countries over time. A country which at a certain point in time may have an initial advantage in some technology may be able over time to strengthen this advantage through an ‘‘accumulation of experience’’, while a country which did not have this advantage may fall further back in the course of time. But while path dependence is an often-encountered phenomenon path change is not so. Social scientists seem to be less interested nowadays to study social dynamics 1
Military history offers numerous examples of technological inertia. Glete (2000) mentions the case of the Portuguese inability during the 17th century to modernize its shipping technology to face the competition of the Dutch and English navies. 2 The formal institutional framework includes firms, organizations, laws and property rights, while the informal one comprises norms, unwritten rules, taboos, traditions and codes of conduct (North, 1990).
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asking what creates ‘‘great changes in the social structure (institutions and organizations) and functions (processes) during small or greater time periods’’.3 These changes concern in fact a change of an institutional regime, and designate a bifurcation or a break in the historic path, sometimes instigated by an external shock. New Institutional Economists have focused upon gradual macro-historic change that brings about in some cases a transition of regime. North (1978, 1981, 1990, 1994) has been the main exponent of this idea of institutional change studying the conditions that shape it and analyzing historical examples of successful transition (England and the Netherlands in the 17th century) as against unsuccessful ones (Spain and France in the same century). North’s approach incorporates the historical complexity of institutional change recognizing that the historical context in which a specific change takes place is crucial in determining how that change unfolds (Fogel, 1997). This approach has been further developed by other scholars who take into account such various aspects as the effects of warfare on taxation (Hoffman and Rosenthal, 1997), the credibility of sovereigns to observe their obligations vis-a`-vis their debtors (North and Weingast, 1989; Weingast, 1997), and the interrelations of economic, social, political and normative factors in medieval societies (Greif, 1997). One can also distinguish historical cases where institutional change and transition to a new social and political regime have been faster and more discontinuous. These cases are often related to the impact that an external threat of great magnitude had on these states, forcing upon them a change of regime in order to meet successfully the threat and survival.4 The process of transition from planned to market economy presents similar characteristics of discontinuous institutional change with the important difference, that it was decided and broadly supported by the citizens themselves.
Values and incentives of collective versus liberal societies Behavior in general, and economic behavior in particular, is influenced by social norms and values, moral considerations, customs and habits. The importance of these factors has been thoroughly recognized by such economists as Arrow (1974, 1994), North (1981, 1990), Bush (1987) and Hodgson (1997, 2001), and has been confirmed by some experimental studies (Dawes and Thaler, 1988; Hoffman and Spitzer, 1985). Arrow (1974, p. 23), for example, has suggested that social values such as trust, loyalty and truth are ‘‘. commodities . which increase the efficiency of the economic system’’, while North (1990, p. 86) emphasizes the role of social rules and customs in reducing transaction costs and ensuring institutional change, 3 F.A. Allen, Socio-cultural dynamics, 1971, quoted in Terlexis (1974) who gives a birds-eye view of the very active field of social change theories in the 1960’s. 4 History offers many such cases: Themistocles with his Naval Law proposed significant changes to face the threat of the Persian invader (Kyriazis and Zouboulakis, 2004). Similarly, Elizabeth I of England has introduced several institutional changes to face the menace of the Spanish Empire (Kyriazis and Zouboulakis, 2002).
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which is apprehended as a change in the set of rules. In contrast, Greif (1997, p. 85) stresses that: One’s utility loss from acting against her values compels the individual to act in a manner that is not the most beneficial in terms of economic reward (and economic efficiency, we may add). Hence, individuals identical in all but their values would choose different actions in the same situation. Accordingly, to understand the fundamentals of social change one needs to consider the culture and values that determine economic behavior and choices since ‘‘values function as the standards of judgement by which behavior is correlated’’ (Bush, 1987, p. 512). As Landes (1998, p. 516) put it ‘‘the values and attitudes that guide members of society is the key to economic development of Nations’’. By appropriately defining values, one can in part explain the economic disparities between societies as differences in the value system. Values are, of course, not fixed forever, but change gradually over time according to the interplay of economic, political and cultural forces (North, 1990, p. 87). Occasionally, values can also be imposed by force to a defeated and occupied country, as shown by the case of transplantation of Western values to traditional societies of the New world, as well as the ‘espousal’ of collectivist values in the countries of Eastern Europe after the Soviet postwar invasion. New values prevailed in those cases once they persisted over a long time period, through a kind of learning process of cultural inheritance to future generations, thus creating path dependence over time. After 1989 and the breakdown of the communist regimes, the system of values has been significantly altered by major changes in the political regime in the East European countries. Yet, because current values are a product of current behavior and past values, whereas current behavior is determined by past values, cultural beliefs, and the economic cost and benefit of various actions, economic change can, over time, alter values (Greif, 1997).5 In our two-game model below, we try to illustrate this with an important modification: we combine changes in the value system with economic changes in a mechanism where the two are interdependent and influence each other in a repeated game. That is to say, there is no unilateral influence from value change to economic change or from economic change to value change, but a two-sided interaction6. Still, path dependence explains the slowness of change in economic behavior and social structures and consequently why economic changes take longer in transition economies. Values and cultural beliefs are incorporated also in organizations, including firms. Organizational development itself is a historical/evolutionary process, in which existing organizations impact the responses of individuals and societies to exogenous changes e like the change of the political regime e and determine incentives with 5
Bowles (1998) explains how market economies shape individual preferences and form social values. In his theoretical model Bush (1987) had defined institutional change as a change in the value structure of the society unilaterally. When, what he calls, ‘‘instrumental values’’ prevail over ‘‘ceremonial values’’, then the change is called ‘‘progressive’’ from the market-like economic organization point of view. 6
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respect to the introduction of new organizations. Past organizations direct future institutional and organizational development (Nelson and Winter, 1982). Sometimes organizational lock-in can be so high, as to inhibit change completely, even when external conditions make this necessary. As Greif (1997, p. 86) wrote A value system may be maintained e or at least slow to change e even when the underlying conditions render it economically inefficient. Following the development of supporting values, a larger change in the underlying conditions is required to alter behavior. In this case, change can be brought about only through ‘‘creative destruction’’ to use Schumpeter’s famous expression, that is, old organizations have to be destroyed, old firms that cannot adapt into the new circumstances must close down to be replaced by new ones, a process that is certainly costly and time consuming and characterizes to a higher or lower degree all economies in transition. We distinguish for our purposes two sets of values, the collectivistic, corresponding to the ‘‘old game’’ of the communist organization, and the individualistic corresponding to the ‘‘new’’ game of the market economy. The collectivistic values inherited from communist regimes stress reliance on the state, state guidance, interference and programming and give less importance to market forces and solutions.7 The individuals see the state as the main provider of goods and personal ‘security’ with regard to education, health, pensions and others. On the contrary, individualistic cultural values emphasize self-reliance of individuals, faith in market forces, less state interference and a framework of stable formal enforcement rules that support anonymous exchange, to permit society to capture all efficiency gains. An individualistic society entails less social pressure to conform to social norms of behavior and therefore fosters initiative and innovation. Many recent empirical studies have pointed out that transition countries are also facing serious institutional handicaps, beyond the well known structural weaknesses related to their outworn economies (high share of traditional agriculture in GDP, obsolete technology, cheap labour, and high-energy consumption).8 Several transition economies face fundamental obstacles due to their former communist institutional legacy which maintains an ‘‘economic environment that [discourages] increasing productivity’’, to adjust North’s (1991, p. 98) words. Insecurity of property rights, the absence of a stable legal frame determining in permanent way the rules of the game, soft budget constraints, that is governmental inability to impose financial discipline both to private and to state-owned firms and, of course, corruption are among the institutional failures often cited.9
7
Resnick and Wolff (2002) define meticulously the characteristics of ‘‘State Capitalism’’ in the USSR and deny the ‘‘communist’’ character of the regime. 8 For a brief survey of these structural weaknesses see Wallden (1994), Panteladis and Petrakos (2000), Totev (2002). 9 On state failures in transition countries see Stiglitz (1994), and Rizopoulos (1999). Stiglitz is dealing extensively with the soft budget constraints issue. Corruption as a major obstacle of economic performance in the Balkan countries was discussed by. Bardham (1997), Jackson (2002), Garabed (2002).
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The ensemble of those institutional handicaps is often illustrated as ‘‘lack of competition culture’’. This is a key issue related to the problem of ownership and control in business firms. In the Balkan transition countries ‘‘the old modes of thinking impede their ability to recognize their new economic functions’’ (Stiglitz, 1994, p. 216). The World Bank reported in 2000 that ‘‘business groups run by former officials of the old communist regime, wield enormous economic power, largely because of the continuing strength of the patronage networks and other personal connections linking members of the old nomenklatura together’’ (Jackson, 2002, p. 85). Even today, the ‘‘visible fist’’ of collectivism often thwarts the ‘‘invisible hand’’ of the market in the process of transformation of transition economies. In a recent study based on an extensive survey by questionnaires of Balkan entrepreneurs,10 Liargovas and Chionis (2002) put the above in a very clear way. According to the results of the survey, the most significant barriers to the transition of enterprises from central plan to market economy were: ‘‘attitudes and values accounting for 40% of the total, followed by the business environment 25%, and skills and knowledge with 35%.’’ In a further desegregation between state’s (which corresponds more or less to the players of the ‘‘old or the communist game’’ in our model below) and private entrepreneurs’ attitudes and values scored even higher as a barrier, reaching 49% of total, as compared with 31% within the sub-category of post-communist entrepreneurs, who correspond to our players of the ‘‘new or the capitalist game.’’ According to the aforementioned study, major values and customs inhibiting change in these economies included: (1) doing practically no work whatever is a status symbol among wide strata of people employed, (2) mistaken conceptions of the world around them by men of power because they had never traveled before to a non-Communist country and could not speak any foreign languages, (3) putting the brakes in any attempt by their subordinates to introduce even minor reforms until it was too late, (4) employees’ mentality, a lack of trust in improving their work, (5) unwillingness of the staff to change their stereotypes due to their mentality formed in the past decades, (6) a false sense of security taken over from the Communist era, that whether you stay, or you lay you will be paid your salary, and related to this, (7) an unwillingness of employers to dismiss people, and (8) the communist mentality, that wages must be differentiated according to employee’s years in the firm, not to their competence and knowledge.
The model of institutional change Fig. 1 illustrates the basic model and possible outcomes. OR illustrates the ‘‘old regime’’ of the communist era. UB and LB are the upper and the lower boundaries that illustrate path dependence or inertia that does not permit change. Change may come about through an external shock, like the breakdown of the old political 10 The survey included entrepreneurs from the following Balkan transition countries: Albania, Bulgaria, Romania, Former Yugoslav Republic of Macedonia, BosniaeHerzegovina, Croatia and FR Yugoslavia.
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NR2 Regime Paths NR1
S2 UB S1 OR
LB
1989
t
Fig. 1. Path dependence and regime paths.
regime in 1989. This corresponds to either a relatively small, or a bigger sudden adaptation. If the shock-adaptation is not big enough, like S1, the forces of inertia bring the situation back towards convergence to the old path. If the shock e adaptation is strong enough, like S2 then the economy may break the boundaries of the old regime and start developing directly along NR1, the new ‘‘capitalist’’ regime. If, on the other hand, after 1989 an economy in transition shows a high degree of inertia, then transition may take a much longer time, that will permit gradual change GC along the old regime path, till enough ‘‘new forces’’ are gathered to break from the old path and bring the economy towards development along the new regime 2. The various possibilities of the model can be formalized as follows: 1. OR Z a C bt 2. UB Z a C c C bt 3. LB Z a d C bt 1e3 gives the central path and the upper and lower boundaries of the ‘‘old regime’’; a, is a constant that denotes the origin in time when the analysis of the regime begins; b is a constant that denotes the gradient of the old regime’s development through time; c and d are constants that denote, respectively, the upper and the lower limits of the path of the old regime. They can be interpreted as the ‘‘distance’’ from the central path within which the ‘‘attraction’’ of the path is so strong that it does not allow change.
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4. OR Z a C bt C S1egt It gives the situation of convergence after a small initial shock, that is, if S1 ! c, that does not succeed in breaching the upper boundary. 5. NR1 Z a C bt C S2egt In this case, the shock is big enough to break the boundary, which is S2 O a. 6. NR2 Z a C bt C egt This illustrates gradual change, with the term egt that characterizes the new regime becoming dominant over time. We now turn into a game theory formulation of the last possibility, which means gradual change. The general idea is that in transition economies the economic agents, the ‘‘players of the game’’, play actually two kinds of games. Those who are used to the customs, rules, habits and so on, that prevailed in the old communist regime, play the so-called ‘‘old game’’; they have not yet adapted to the new reality, but are bound by inertia. Those who have succeeded in breaking with old habits, rules, and customs play the ‘‘new’’ capitalist game. The following hypothetical ‘‘payoff’’ matrix of a multi-period game illustrates the situation: Payoff matrix Time period
Old game
New game
Welfare outcome, total
0 1 2 3
140 100 80 40
e 30 (h) 40 (h C it) 110 (h C itC1)
140 130 120 150
(n) (m) (m it) (m itC1)
(n) (n) (n) (n)
There are n players e economic agents in the play, and we assume for simplicity, that this number remains stable over the game horizon. In the period 1, out of n players, m players still play the ‘‘old’’ game, and h play the ‘‘new’’ one, with n Z m C h. The welfare total for the m players is 100 and for the h is 30, with total welfare of the two groups 130. We can safely assume that in the first period most players still play the ‘‘old’’ game, that is, m O h. We further assume that all players play the ‘‘old’’ game equally well. As to the ‘‘new’’ game, some out of h players play it well (the good players whom we label s), while the rest, (h s), play it badly, because they have not yet acquired the skill that the new game requires. Thus, we have h Z s C (h s). During the second period, some of the players who played the ‘‘old’’ game before, decide, or are compelled by circumstance, to move over and play the ‘‘new’’ game. The change of players from one type of game to the other per period is characterized by itC1. Within the players playing the ‘‘new’’ game, the numbers of good and bad players also change, that is, we have additions to both s, and P1 s of period 1. Some of the ‘‘bad’’ players of the first period have acquired enough experience and skill to play now the ‘‘new’’ game well, and even some of the newcomers from those that played the ‘‘old’’ game in the first period, may be ‘‘good’’ players. Welfare of the first group is being reduced, while that of the second group increases in total,
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but possibly not so much as to compensate the loss of welfare in the first group, perhaps because the ‘‘bad’’ players in this period within the new game group strongly predominate. Thus, we may have a reduction in total welfare. During the third period, more people have gone over from playing the ‘‘old’’ game to playing the ‘‘new’’. We assume also, that the ‘‘good’’ players within the ‘‘new’’ game start to predominate little by little. This gives a positive total outcome for welfare. The economy has at last started to move successfully along the new regime path NR2. The individual welfare situation for each period and the three categories of players, who are players of the ‘‘old’’ game W0, ‘‘good’’ players of the ‘‘new’’ game Wg, and ‘‘bad’’ players of the ‘‘new’’ game Wb, may look like this: Period 1: Wg O W0 O Wb Period 2: Wg O W0 R Wb or Wg O W0 ! Wb Period 3: Wg O Wb O W0 Individual players maximize, thus, their expected payoffs, Wi Z max{Wln, Wlo}, with Wln being the expected payoff for the ‘‘new’’ game, and Wlo the expected payoff for the ‘‘old’’ game, both for player i. Actually, each individual maximizes his/her expected payoff under some kind of uncertainty, since he/she is not sure that the expected payoff will correspond to the actual outcome of the game. Hence, an individual may expect that Wlo O Wln and thus choose to play the ‘‘old’’ game, but the actual outcome may be Wo ! Wlo, or Wo ! Wln, even if he/she is a ‘‘bad’’ player of the new game. In all periods, ‘‘good’’ players achieve better individual welfare than ‘‘bad’’ and ‘‘old’’ players. In the first period, ‘‘old’’ players achieve better welfare than ‘‘bad’’ players, and this may help explain inertia, that is, many of the ‘‘old’’ players are uncertain if they could improve their situation by playing the ‘‘new’’ game. In the second period, again the outcome between ‘‘old’’ and ‘‘bad’’ players is uncertain, but at least some ‘‘bad’’ players might get better playing the ‘‘new’’ game. In the third period, the welfare situation of those who continue to play the ‘‘old’’ game (the ‘‘diehards’’) has become so bad, that even ‘‘bad’’ players are better-off. Here, all ‘‘old’’ players have an incentive to start playing the ‘‘new’’ game. What actually characterizes endogenous change in the model are two components: first, the rate of change of players from the one game type to the other, which we call the ‘‘going-over’’ rate. The faster this rate progresses, the faster is the transition from the old to the new regime. Second, the ‘‘learning’’ rate, that is to say, how fast players that play the ‘‘new’’ game adapt to become also ‘‘good’’ players. The combination of these two rates actually specifies the rate of change e growth g in Eq. 6. 7a. ‘‘Going-over’’ rate: itCv with v Z 1, ., u time periods 7b. ‘‘Learning rate’’: the proportion of ‘‘good’’ to ‘‘bad’’ players per period,
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St Cv h StCv with StCv being the variable that distributes the ‘‘going-over’’ rate between ‘‘bad’’ and ‘‘good’’ players of the ‘‘new’’ game. Thus, the ‘‘growth’’ rate g in Eq. 6, can be expressed using these two rates, as 8. gtCv Z
St Cv ðhCitCv Þ h StCv
The higher the StCv and itCv , the higher the gtCv , or the rate of change from the old to the new regime. Conclusion We have presented above a simple game theory model that attempts to capture the difficulties of transition to market economy of the former communist countries. According to it, the timing of transition depends on the proportion of ‘‘bad’’ to ‘‘good’’ players of the ‘‘new’’ game, and the ‘‘going-over’’ rate, both of them depending on cultural and institutional factors, and less on successful or less successful macroeconomic and stabilization policies, Macroeconomic policies are of course important in addressing questions like lowering inflation, (Chionis and Kyriazis, in press) but may be less so in addressing long-run objectives like economic growth, which depends, mainly on institutional and cultural factors. So the population of countries which had an old established ‘‘capitalist’’ tradition, like the Czech Republic, are more likely to learn to play the ‘‘new’’ game faster, and their ‘‘going-over’’ rate may also be faster than countries like Albania, where such a tradition never existed. Also, countries where some steps of institutional change started, even timidly, during the communist regime, had a time advantage, that is, they started to learn playing the ‘‘new’’ game earlier than the countries where this was not the case. Panagiotou (2001) for example proposes that Estonia’s relatively more successful transition process than that of the two other Baltic States, Latvia and Lithuania, is due to the fact that favorable conditions for institutional change were already established there during the communist regime, while they had not been created in the other two states. Coase (1992) remarked that ‘‘without the appropriate Institutions no market economy of any significance is possible’’. To shift from plan to market system of organization implies first of all a set of reforms of the formal rules e like the legal system, the banking system, capital-markets, and the informal rules e which determine the system of incentives of the individuals who govern economic activity and behavior. While the significance of the formal institutions is broadly acknowledged in the transition literature, the role of the system of norms, values and incentives is far from being recognized as such, despite its key role for countries in transition. Marshall (1890, p. 115) has suggested that ‘‘Capital consists in a great
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part of knowledge and organization. Knowledge is our most powerful engine of production’’. Therefore, to ensure transition and future development one should start from reforming learning institutions at all levels (schools, universities, professional training) to shape ‘‘the kinds of skills and knowledge that pay off’’ (North, 1990, p. 78). Education, not only formal education but also learning procedures in general, is a major determinant of innovation and therefore a cause of increasing returns, spillovers, and social returns conducive to growth.
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Jackson, M., 2002. Politics and transition lags in southeastern Europe: will, ability or possibility. In: Kotios, A., Petrakos, G. (Eds.), Restructuring and Development in Southeastern Europe. University of Thessaly Press, Volos. Krugman, P., 1991. History and industry location: the case of the manufacturing belt. American Economic Review 81, 80e83. Kyriazis, N., Zouboulakis, M., 2002. Private law for public benefit: property rights arrangements in Elizabethan England. Communication presented at the 19th Annual Conference of the European Association of Law and Economics, Athens. Kyriazis, N., Zouboulakis, M., 2004. Democracy, sea power and institutional change. An economic analysis of the Athenian Naval Law. European Journal of Law and Economics 17 (1), 117e132. Landes, D., 1998. The wealth and poverty of nations. Little, Brown & Co., London. Marshall, A., 1890. Principles of economics, eighth ed. MacMillan Press, London (1985). Liargovas, P., Chionis, D., 2002. Barriers to the transition of enterprises from central plan to market economy: the Balkan case. Journal of Southern Europe and the Balkans 4 (2). Nelson, R., Winter, S., 1982. An evolutionary theory of economic change. Harvard University Press, Cambridge, MA. North, D.C., 1978. Structure and performance: the task of economic history. Journal of Economic Literature 16 (3), 963e978. North, D.C., 1981. Structure and change in economic history. W.W. Norton & Co., London. North, D.C., 1990. Institutions, institutional change and economic performance. Cambridge University Press, Cambridge. North, D.C., 1991. Institutions. Journal of Economic Perspectives 5 (1), 97e112. North, D.C., 1994. Economic performance through time. American Economic Review 84 (3), 359e368. North, D.C., Weingast, B.R., 1989. Constitutions and commitment: the evolution of institutions governing public choice in 17th century England. Journal of Economic History 59, 803e832. Panagiotou, R., 2001. Estonia’s success: prescription or legacy? Communist and Post-Communist Studies 34, 261e277. Panteladis, J., Petrakos, G., 2000. Economic and structural characteristics of the Balkan countries. In: Petrakos, G. (Ed.), The Development of the Balkans. University of Thessaly Press, Volos (in Greek). Pejovich, S., 2002. Understanding the Transaction Costs of Transition: It’s the Culture Stupid. Communication at the 19th Annual Conference of the European Association of Law and Economics, Athens. Persson, T., 2002. Do political institutions shape economic policy? Econometrica 70 (3), 883e905. Resnick, S., Wolff, R., 2002. Class theory and history. Routledge, London. Rizopoulos, Y., 1999. Quelle est la spe´cificite´ des transitions balkaniques? Revue d’e´tudes comparatives Est-ouest 30 (4), 5e13. Stiglitz, J., 1994. Whither socialism? MIT Press, Cambridge MA. Terlexis, P., 1974. Social progress and social change. The Greek Review of Social Research 23, 62e68 (in Greek). Totev, S., 2002. Economic performance and structure in Southeastern European countries. In: Kotios, A., Petrakos, G. (Eds.), Restructuring and Development in Southeastern Europe, University of Thessaly Press, Volos, pp. 153e179. Wallden, S., 1994. Balken cooperation and European Integration, Papazissis, Athens (in Greek). Weingast, B.R., 1997. The political foundations of limited government: parliament and sovereign debt in 17th and 18th century England. In: Drobak, J.N., Nye, J.V.C. (Eds.). Zouboulakis, M., 2002. Path Dependence and the Institutional Determinants of Growth. Communication at the 8th Economic Society of Thessaloniki International Conference, Thessaloniki: University of Macedonia Press.
Further reading North, D.C., 1984. Transaction costs, institutions and economic history. Journal of Theoretical and Institutional Economics 140, 7e17.
Modeling institutional change in transition economies Nicholas C. Kyriazis*, Michel S. Zouboulakis Department of Economics, University of Thessaly, Argonauton Str. 38221 Volos, Greece
Abstract A particular aspect of path dependence and change is discussed here. To understand institutional change in transition economies, a game theoretic model that combines economic changes with changes in the social values system is proposed, in a mechanism where the two changes are interdependent and influence one another in a repeated game. The speed of change in this dynamic model is the result of two rates, the ‘‘learning rate’’, how fast agents are learning to play the new ‘‘capitalist’’ game and the so-called ‘‘going-over rate’’, the mix in every time period of economic agents playing according to the ‘‘old’’ communist values and those playing according to the ‘‘new’’ capitalist values. Ó 2005 The Regents of the University of California. Published by Elsevier Ltd. All rights reserved. Keywords: Transition economies; Game theory; Path dependence and change
Lock-in and social change The idea of path dependence has raised considerable interest in its various aspects. A path dependent process of economic evolution is defined as one in which ‘‘important influences upon the eventual outcome can be exerted by temporarily
* Corresponding author. Tel.: C30 24210 74882; fax: C30 24210 74772. E-mail address: [email protected] (M.S. Zouboulakis). 0967-067X/$ - see front matter Ó 2005 The Regents of the University of California. Published by Elsevier Ltd. All rights reserved. doi:10.1016/j.postcomstud.2005.01.004
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remote events, including happenings dominated by chance elements rather than systematic forces’’ (David, 1985). This process is characterized by inertia, once an outcome begins to stabilize, it becomes progressively locked to attractors not always optimal, and by ‘‘non-ergodicity’’ in that historical ‘‘small events’’ are not averaged away and ‘‘forgotten’’ by the dynamics of the evolution of the economy (Arthur, 1989). David (2002, p. 19) offers a definition which can be helpful for the sake of our analysis: ‘‘a path dependent stochastic process is one which asymptotic distribution evolves as a consequence (function) of the process’s own history’’. Economists have distinguished at least three different areas of lock-in: a) Technological: Attempting to explain the possible trapping in inferior technologies (Arthur, 1989; David, 1985, 1994). Thus, Nelson and Winter (1982, p. 237) have explained technological lock-in: ‘‘It is time consuming and costly for a firm to learn about, and learn to use technology significantly different from that with which it is familiar’’. The cost of introducing new technologies may be perceived by some firms as being higher than what it actually is.1 Still, they further elaborate this idea to suggest the ‘‘neighborhood’’ concept e successful choices made today can guide and prepare those that will be made tomorrow. The result of today’s research, besides offering a successful new technology, can become a natural starting point for tomorrow’s research. Consequently, technology becomes ‘‘cumulative’’. b) Institutional: Examining why national economies can be stuck with inefficient institutions that inhibit growth (North, 1981, 1990; Hodgson, 1999, 2001). Or, more generally, how electoral rules and political regimes shape economic policy (Persson, 2002). Relatively to institutional lock-in, a growing number of scholars try to explain the slowness of transition of former communist countries to market economies by focusing on the institutional framework, both formal and informal,2 inherited by the old communist regimes that is very slow to adapt and change. (Rizopoulos, 1999; Pejovich, 2002; Zouboulakis, 2002). c) Spatial: Concerning firm location and its impact on regional development (Krugman, 1991; Fotopoulos and Spence, 1999). Similarly, Gilpin (2002) uses the concept of path dependence in order to explain competitive advantages of different countries over time. A country which at a certain point in time may have an initial advantage in some technology may be able over time to strengthen this advantage through an ‘‘accumulation of experience’’, while a country which did not have this advantage may fall further back in the course of time. But while path dependence is an often-encountered phenomenon path change is not so. Social scientists seem to be less interested nowadays to study social dynamics 1
Military history offers numerous examples of technological inertia. Glete (2000) mentions the case of the Portuguese inability during the 17th century to modernize its shipping technology to face the competition of the Dutch and English navies. 2 The formal institutional framework includes firms, organizations, laws and property rights, while the informal one comprises norms, unwritten rules, taboos, traditions and codes of conduct (North, 1990).
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asking what creates ‘‘great changes in the social structure (institutions and organizations) and functions (processes) during small or greater time periods’’.3 These changes concern in fact a change of an institutional regime, and designate a bifurcation or a break in the historic path, sometimes instigated by an external shock. New Institutional Economists have focused upon gradual macro-historic change that brings about in some cases a transition of regime. North (1978, 1981, 1990, 1994) has been the main exponent of this idea of institutional change studying the conditions that shape it and analyzing historical examples of successful transition (England and the Netherlands in the 17th century) as against unsuccessful ones (Spain and France in the same century). North’s approach incorporates the historical complexity of institutional change recognizing that the historical context in which a specific change takes place is crucial in determining how that change unfolds (Fogel, 1997). This approach has been further developed by other scholars who take into account such various aspects as the effects of warfare on taxation (Hoffman and Rosenthal, 1997), the credibility of sovereigns to observe their obligations vis-a`-vis their debtors (North and Weingast, 1989; Weingast, 1997), and the interrelations of economic, social, political and normative factors in medieval societies (Greif, 1997). One can also distinguish historical cases where institutional change and transition to a new social and political regime have been faster and more discontinuous. These cases are often related to the impact that an external threat of great magnitude had on these states, forcing upon them a change of regime in order to meet successfully the threat and survival.4 The process of transition from planned to market economy presents similar characteristics of discontinuous institutional change with the important difference, that it was decided and broadly supported by the citizens themselves.
Values and incentives of collective versus liberal societies Behavior in general, and economic behavior in particular, is influenced by social norms and values, moral considerations, customs and habits. The importance of these factors has been thoroughly recognized by such economists as Arrow (1974, 1994), North (1981, 1990), Bush (1987) and Hodgson (1997, 2001), and has been confirmed by some experimental studies (Dawes and Thaler, 1988; Hoffman and Spitzer, 1985). Arrow (1974, p. 23), for example, has suggested that social values such as trust, loyalty and truth are ‘‘. commodities . which increase the efficiency of the economic system’’, while North (1990, p. 86) emphasizes the role of social rules and customs in reducing transaction costs and ensuring institutional change, 3 F.A. Allen, Socio-cultural dynamics, 1971, quoted in Terlexis (1974) who gives a birds-eye view of the very active field of social change theories in the 1960’s. 4 History offers many such cases: Themistocles with his Naval Law proposed significant changes to face the threat of the Persian invader (Kyriazis and Zouboulakis, 2004). Similarly, Elizabeth I of England has introduced several institutional changes to face the menace of the Spanish Empire (Kyriazis and Zouboulakis, 2002).
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which is apprehended as a change in the set of rules. In contrast, Greif (1997, p. 85) stresses that: One’s utility loss from acting against her values compels the individual to act in a manner that is not the most beneficial in terms of economic reward (and economic efficiency, we may add). Hence, individuals identical in all but their values would choose different actions in the same situation. Accordingly, to understand the fundamentals of social change one needs to consider the culture and values that determine economic behavior and choices since ‘‘values function as the standards of judgement by which behavior is correlated’’ (Bush, 1987, p. 512). As Landes (1998, p. 516) put it ‘‘the values and attitudes that guide members of society is the key to economic development of Nations’’. By appropriately defining values, one can in part explain the economic disparities between societies as differences in the value system. Values are, of course, not fixed forever, but change gradually over time according to the interplay of economic, political and cultural forces (North, 1990, p. 87). Occasionally, values can also be imposed by force to a defeated and occupied country, as shown by the case of transplantation of Western values to traditional societies of the New world, as well as the ‘espousal’ of collectivist values in the countries of Eastern Europe after the Soviet postwar invasion. New values prevailed in those cases once they persisted over a long time period, through a kind of learning process of cultural inheritance to future generations, thus creating path dependence over time. After 1989 and the breakdown of the communist regimes, the system of values has been significantly altered by major changes in the political regime in the East European countries. Yet, because current values are a product of current behavior and past values, whereas current behavior is determined by past values, cultural beliefs, and the economic cost and benefit of various actions, economic change can, over time, alter values (Greif, 1997).5 In our two-game model below, we try to illustrate this with an important modification: we combine changes in the value system with economic changes in a mechanism where the two are interdependent and influence each other in a repeated game. That is to say, there is no unilateral influence from value change to economic change or from economic change to value change, but a two-sided interaction6. Still, path dependence explains the slowness of change in economic behavior and social structures and consequently why economic changes take longer in transition economies. Values and cultural beliefs are incorporated also in organizations, including firms. Organizational development itself is a historical/evolutionary process, in which existing organizations impact the responses of individuals and societies to exogenous changes e like the change of the political regime e and determine incentives with 5
Bowles (1998) explains how market economies shape individual preferences and form social values. In his theoretical model Bush (1987) had defined institutional change as a change in the value structure of the society unilaterally. When, what he calls, ‘‘instrumental values’’ prevail over ‘‘ceremonial values’’, then the change is called ‘‘progressive’’ from the market-like economic organization point of view. 6
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respect to the introduction of new organizations. Past organizations direct future institutional and organizational development (Nelson and Winter, 1982). Sometimes organizational lock-in can be so high, as to inhibit change completely, even when external conditions make this necessary. As Greif (1997, p. 86) wrote A value system may be maintained e or at least slow to change e even when the underlying conditions render it economically inefficient. Following the development of supporting values, a larger change in the underlying conditions is required to alter behavior. In this case, change can be brought about only through ‘‘creative destruction’’ to use Schumpeter’s famous expression, that is, old organizations have to be destroyed, old firms that cannot adapt into the new circumstances must close down to be replaced by new ones, a process that is certainly costly and time consuming and characterizes to a higher or lower degree all economies in transition. We distinguish for our purposes two sets of values, the collectivistic, corresponding to the ‘‘old game’’ of the communist organization, and the individualistic corresponding to the ‘‘new’’ game of the market economy. The collectivistic values inherited from communist regimes stress reliance on the state, state guidance, interference and programming and give less importance to market forces and solutions.7 The individuals see the state as the main provider of goods and personal ‘security’ with regard to education, health, pensions and others. On the contrary, individualistic cultural values emphasize self-reliance of individuals, faith in market forces, less state interference and a framework of stable formal enforcement rules that support anonymous exchange, to permit society to capture all efficiency gains. An individualistic society entails less social pressure to conform to social norms of behavior and therefore fosters initiative and innovation. Many recent empirical studies have pointed out that transition countries are also facing serious institutional handicaps, beyond the well known structural weaknesses related to their outworn economies (high share of traditional agriculture in GDP, obsolete technology, cheap labour, and high-energy consumption).8 Several transition economies face fundamental obstacles due to their former communist institutional legacy which maintains an ‘‘economic environment that [discourages] increasing productivity’’, to adjust North’s (1991, p. 98) words. Insecurity of property rights, the absence of a stable legal frame determining in permanent way the rules of the game, soft budget constraints, that is governmental inability to impose financial discipline both to private and to state-owned firms and, of course, corruption are among the institutional failures often cited.9
7
Resnick and Wolff (2002) define meticulously the characteristics of ‘‘State Capitalism’’ in the USSR and deny the ‘‘communist’’ character of the regime. 8 For a brief survey of these structural weaknesses see Wallden (1994), Panteladis and Petrakos (2000), Totev (2002). 9 On state failures in transition countries see Stiglitz (1994), and Rizopoulos (1999). Stiglitz is dealing extensively with the soft budget constraints issue. Corruption as a major obstacle of economic performance in the Balkan countries was discussed by. Bardham (1997), Jackson (2002), Garabed (2002).
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The ensemble of those institutional handicaps is often illustrated as ‘‘lack of competition culture’’. This is a key issue related to the problem of ownership and control in business firms. In the Balkan transition countries ‘‘the old modes of thinking impede their ability to recognize their new economic functions’’ (Stiglitz, 1994, p. 216). The World Bank reported in 2000 that ‘‘business groups run by former officials of the old communist regime, wield enormous economic power, largely because of the continuing strength of the patronage networks and other personal connections linking members of the old nomenklatura together’’ (Jackson, 2002, p. 85). Even today, the ‘‘visible fist’’ of collectivism often thwarts the ‘‘invisible hand’’ of the market in the process of transformation of transition economies. In a recent study based on an extensive survey by questionnaires of Balkan entrepreneurs,10 Liargovas and Chionis (2002) put the above in a very clear way. According to the results of the survey, the most significant barriers to the transition of enterprises from central plan to market economy were: ‘‘attitudes and values accounting for 40% of the total, followed by the business environment 25%, and skills and knowledge with 35%.’’ In a further desegregation between state’s (which corresponds more or less to the players of the ‘‘old or the communist game’’ in our model below) and private entrepreneurs’ attitudes and values scored even higher as a barrier, reaching 49% of total, as compared with 31% within the sub-category of post-communist entrepreneurs, who correspond to our players of the ‘‘new or the capitalist game.’’ According to the aforementioned study, major values and customs inhibiting change in these economies included: (1) doing practically no work whatever is a status symbol among wide strata of people employed, (2) mistaken conceptions of the world around them by men of power because they had never traveled before to a non-Communist country and could not speak any foreign languages, (3) putting the brakes in any attempt by their subordinates to introduce even minor reforms until it was too late, (4) employees’ mentality, a lack of trust in improving their work, (5) unwillingness of the staff to change their stereotypes due to their mentality formed in the past decades, (6) a false sense of security taken over from the Communist era, that whether you stay, or you lay you will be paid your salary, and related to this, (7) an unwillingness of employers to dismiss people, and (8) the communist mentality, that wages must be differentiated according to employee’s years in the firm, not to their competence and knowledge.
The model of institutional change Fig. 1 illustrates the basic model and possible outcomes. OR illustrates the ‘‘old regime’’ of the communist era. UB and LB are the upper and the lower boundaries that illustrate path dependence or inertia that does not permit change. Change may come about through an external shock, like the breakdown of the old political 10 The survey included entrepreneurs from the following Balkan transition countries: Albania, Bulgaria, Romania, Former Yugoslav Republic of Macedonia, BosniaeHerzegovina, Croatia and FR Yugoslavia.
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NR2 Regime Paths NR1
S2 UB S1 OR
LB
1989
t
Fig. 1. Path dependence and regime paths.
regime in 1989. This corresponds to either a relatively small, or a bigger sudden adaptation. If the shock-adaptation is not big enough, like S1, the forces of inertia bring the situation back towards convergence to the old path. If the shock e adaptation is strong enough, like S2 then the economy may break the boundaries of the old regime and start developing directly along NR1, the new ‘‘capitalist’’ regime. If, on the other hand, after 1989 an economy in transition shows a high degree of inertia, then transition may take a much longer time, that will permit gradual change GC along the old regime path, till enough ‘‘new forces’’ are gathered to break from the old path and bring the economy towards development along the new regime 2. The various possibilities of the model can be formalized as follows: 1. OR Z a C bt 2. UB Z a C c C bt 3. LB Z a d C bt 1e3 gives the central path and the upper and lower boundaries of the ‘‘old regime’’; a, is a constant that denotes the origin in time when the analysis of the regime begins; b is a constant that denotes the gradient of the old regime’s development through time; c and d are constants that denote, respectively, the upper and the lower limits of the path of the old regime. They can be interpreted as the ‘‘distance’’ from the central path within which the ‘‘attraction’’ of the path is so strong that it does not allow change.
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4. OR Z a C bt C S1egt It gives the situation of convergence after a small initial shock, that is, if S1 ! c, that does not succeed in breaching the upper boundary. 5. NR1 Z a C bt C S2egt In this case, the shock is big enough to break the boundary, which is S2 O a. 6. NR2 Z a C bt C egt This illustrates gradual change, with the term egt that characterizes the new regime becoming dominant over time. We now turn into a game theory formulation of the last possibility, which means gradual change. The general idea is that in transition economies the economic agents, the ‘‘players of the game’’, play actually two kinds of games. Those who are used to the customs, rules, habits and so on, that prevailed in the old communist regime, play the so-called ‘‘old game’’; they have not yet adapted to the new reality, but are bound by inertia. Those who have succeeded in breaking with old habits, rules, and customs play the ‘‘new’’ capitalist game. The following hypothetical ‘‘payoff’’ matrix of a multi-period game illustrates the situation: Payoff matrix Time period
Old game
New game
Welfare outcome, total
0 1 2 3
140 100 80 40
e 30 (h) 40 (h C it) 110 (h C itC1)
140 130 120 150
(n) (m) (m it) (m itC1)
(n) (n) (n) (n)
There are n players e economic agents in the play, and we assume for simplicity, that this number remains stable over the game horizon. In the period 1, out of n players, m players still play the ‘‘old’’ game, and h play the ‘‘new’’ one, with n Z m C h. The welfare total for the m players is 100 and for the h is 30, with total welfare of the two groups 130. We can safely assume that in the first period most players still play the ‘‘old’’ game, that is, m O h. We further assume that all players play the ‘‘old’’ game equally well. As to the ‘‘new’’ game, some out of h players play it well (the good players whom we label s), while the rest, (h s), play it badly, because they have not yet acquired the skill that the new game requires. Thus, we have h Z s C (h s). During the second period, some of the players who played the ‘‘old’’ game before, decide, or are compelled by circumstance, to move over and play the ‘‘new’’ game. The change of players from one type of game to the other per period is characterized by itC1. Within the players playing the ‘‘new’’ game, the numbers of good and bad players also change, that is, we have additions to both s, and P1 s of period 1. Some of the ‘‘bad’’ players of the first period have acquired enough experience and skill to play now the ‘‘new’’ game well, and even some of the newcomers from those that played the ‘‘old’’ game in the first period, may be ‘‘good’’ players. Welfare of the first group is being reduced, while that of the second group increases in total,
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but possibly not so much as to compensate the loss of welfare in the first group, perhaps because the ‘‘bad’’ players in this period within the new game group strongly predominate. Thus, we may have a reduction in total welfare. During the third period, more people have gone over from playing the ‘‘old’’ game to playing the ‘‘new’’. We assume also, that the ‘‘good’’ players within the ‘‘new’’ game start to predominate little by little. This gives a positive total outcome for welfare. The economy has at last started to move successfully along the new regime path NR2. The individual welfare situation for each period and the three categories of players, who are players of the ‘‘old’’ game W0, ‘‘good’’ players of the ‘‘new’’ game Wg, and ‘‘bad’’ players of the ‘‘new’’ game Wb, may look like this: Period 1: Wg O W0 O Wb Period 2: Wg O W0 R Wb or Wg O W0 ! Wb Period 3: Wg O Wb O W0 Individual players maximize, thus, their expected payoffs, Wi Z max{Wln, Wlo}, with Wln being the expected payoff for the ‘‘new’’ game, and Wlo the expected payoff for the ‘‘old’’ game, both for player i. Actually, each individual maximizes his/her expected payoff under some kind of uncertainty, since he/she is not sure that the expected payoff will correspond to the actual outcome of the game. Hence, an individual may expect that Wlo O Wln and thus choose to play the ‘‘old’’ game, but the actual outcome may be Wo ! Wlo, or Wo ! Wln, even if he/she is a ‘‘bad’’ player of the new game. In all periods, ‘‘good’’ players achieve better individual welfare than ‘‘bad’’ and ‘‘old’’ players. In the first period, ‘‘old’’ players achieve better welfare than ‘‘bad’’ players, and this may help explain inertia, that is, many of the ‘‘old’’ players are uncertain if they could improve their situation by playing the ‘‘new’’ game. In the second period, again the outcome between ‘‘old’’ and ‘‘bad’’ players is uncertain, but at least some ‘‘bad’’ players might get better playing the ‘‘new’’ game. In the third period, the welfare situation of those who continue to play the ‘‘old’’ game (the ‘‘diehards’’) has become so bad, that even ‘‘bad’’ players are better-off. Here, all ‘‘old’’ players have an incentive to start playing the ‘‘new’’ game. What actually characterizes endogenous change in the model are two components: first, the rate of change of players from the one game type to the other, which we call the ‘‘going-over’’ rate. The faster this rate progresses, the faster is the transition from the old to the new regime. Second, the ‘‘learning’’ rate, that is to say, how fast players that play the ‘‘new’’ game adapt to become also ‘‘good’’ players. The combination of these two rates actually specifies the rate of change e growth g in Eq. 6. 7a. ‘‘Going-over’’ rate: itCv with v Z 1, ., u time periods 7b. ‘‘Learning rate’’: the proportion of ‘‘good’’ to ‘‘bad’’ players per period,
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St Cv h StCv with StCv being the variable that distributes the ‘‘going-over’’ rate between ‘‘bad’’ and ‘‘good’’ players of the ‘‘new’’ game. Thus, the ‘‘growth’’ rate g in Eq. 6, can be expressed using these two rates, as 8. gtCv Z
St Cv ðhCitCv Þ h StCv
The higher the StCv and itCv , the higher the gtCv , or the rate of change from the old to the new regime. Conclusion We have presented above a simple game theory model that attempts to capture the difficulties of transition to market economy of the former communist countries. According to it, the timing of transition depends on the proportion of ‘‘bad’’ to ‘‘good’’ players of the ‘‘new’’ game, and the ‘‘going-over’’ rate, both of them depending on cultural and institutional factors, and less on successful or less successful macroeconomic and stabilization policies, Macroeconomic policies are of course important in addressing questions like lowering inflation, (Chionis and Kyriazis, in press) but may be less so in addressing long-run objectives like economic growth, which depends, mainly on institutional and cultural factors. So the population of countries which had an old established ‘‘capitalist’’ tradition, like the Czech Republic, are more likely to learn to play the ‘‘new’’ game faster, and their ‘‘going-over’’ rate may also be faster than countries like Albania, where such a tradition never existed. Also, countries where some steps of institutional change started, even timidly, during the communist regime, had a time advantage, that is, they started to learn playing the ‘‘new’’ game earlier than the countries where this was not the case. Panagiotou (2001) for example proposes that Estonia’s relatively more successful transition process than that of the two other Baltic States, Latvia and Lithuania, is due to the fact that favorable conditions for institutional change were already established there during the communist regime, while they had not been created in the other two states. Coase (1992) remarked that ‘‘without the appropriate Institutions no market economy of any significance is possible’’. To shift from plan to market system of organization implies first of all a set of reforms of the formal rules e like the legal system, the banking system, capital-markets, and the informal rules e which determine the system of incentives of the individuals who govern economic activity and behavior. While the significance of the formal institutions is broadly acknowledged in the transition literature, the role of the system of norms, values and incentives is far from being recognized as such, despite its key role for countries in transition. Marshall (1890, p. 115) has suggested that ‘‘Capital consists in a great
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part of knowledge and organization. Knowledge is our most powerful engine of production’’. Therefore, to ensure transition and future development one should start from reforming learning institutions at all levels (schools, universities, professional training) to shape ‘‘the kinds of skills and knowledge that pay off’’ (North, 1990, p. 78). Education, not only formal education but also learning procedures in general, is a major determinant of innovation and therefore a cause of increasing returns, spillovers, and social returns conducive to growth.
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Further reading North, D.C., 1984. Transaction costs, institutions and economic history. Journal of Theoretical and Institutional Economics 140, 7e17.