The Central Role of Institutions 1.2.1 Change in the Institutional Environment

For the institutional environment, path dependency and power are recognised as two critical influences on institutional change. Institutions normally evolve, and thus institutions are often formed by incremental change of earlier institutions. Formal institutions are often more amenable to reform and radical change (through revolution, presidential edict, government policy changes or new laws, for example) but informal institutions, often deeply embedded in culture, adjust more slowly and may pull in opposite directions to (and undermine) changes in formal institutions.

North holds that it is the powerful groups in society who determine the institutional environment, particularly the formal rules. This they do primarily for their own private interests, according to their historical and cultural setting and to their subjective (and ideological) understanding of how the world works. If the powerful groups in society perceive it to be in their interests to develop institutions that encourage trade, then the weaker members of society also prosper. If institutions that are put in place discourage trade, however, the poor suffer. Thus if a country's elite perceive that they will increase their welfare by supporting institutions that encourage trade while taking only a small share of its benefits, this is likely to promote development. If, however, they concentrate on capturing large shares of the benefits of trade (for example through legal or illegal taxes), or try to retain or increase control over particular patterns of economic activity, then this will increase transaction costs and risks and depress development. Understanding institutional change is therefore not a simple question of economics but involves political economy, social anthropology and stakeholder analysis as well as the analysis of market failures in the development of different institutional frameworks.