TOWARD A THEORY OF INDUCED INSTITUTIONAL 
INNOVATION 
by 
Vernon W. Ruttan and Yujiro Hayami 
Discussion Paper No. 200, February, 1984 
Center for Economic Research 
Department of Economics 
Univers ity of Minnesota 
Minneapolis, Minnesota 55455 
Draft 
January 26, 1984 
Toward a Theory of Induced Institutional Innovation** 
by Vernon ~v. Ruttan and Yuj iro Hayami* 
In this paper we elaborate a theory of institutional innovation 
in which changes in the demand fot institutional innovation are 
induced by changes in relative resource endowments and by 
technical change. We illustrate, from agricultural history, 
how changes in resource endowments and technical change have 
induced changes in private property rights and in the development 
of non-market institutions. We also consider the impact of 
advances in social science knowledge and of cultural endowments 
on the supply of institutional change. In a final section we 
present the elements of a model of institutional innovation 
that maps the relationships among resource endowments, cultural 
endowments, technology, and institutions. 
*Professor, Department of Economics and Department of Agricultural and 
Applied Economics, University of Hinnesota, and Professor of Economics, 
Tokyo ~letropolitan University, respectively. He are indebted to Hargaret 
Andre~vs, Robert Bates, David Feeny, Elizabeth Hoffman, Robert Keohane, James 
Roumasset and Ford Runge for comments on an earlier draft of this paper. 
~'~*To be published in a forthcoming issue of The Journal of Development 
Studies. 
2 
The interpretation of technical and institutional change as 
endogenous rather than exogenous to the economic system is a relatively 
new development in economic thought. 
In work published in the early 1970's we extended the theory of 
induced technical change and tested it against the history of agricultural 
development in the United States and Japan [Hayami and Ruttan, 1971; 
Binswanger and Ruttan, 1978; Wade, 1981]. It is now generally accepted 
that the theory of induced technical change provides very substantial 
insight into the process of agricultural development for a wide range 
of developed and developing countries. And economic historians are 
increasingly drawing on the theory of induced technical change in attempt-
ing to interpret differential patterns of productivity growth among 
countries and over time [Cain and Paterson, 1981; Phillips, 1982]. 
The demonstration that technical change can be treated as largely 
endogenous to the development process does not imply that the progress of 
either agricultural or industrial technology can be left to an 'invisible 
3 
hand' that drives technology along an 'efficient' path determined by 
relative resource endowments. The capacity to advance knowledge in science 
and technology is itself a result of a product of institutional innovation--
'the great invention of the 19th century was the invention of the method of 
invention' [Whitehead, 1925:96]. 
In the case of agriculture, for example, in both Japan and the United 
States, much of the technical change that has led to growth of output per 
hectare has been produced by public sector institutions. These institutions--
state (or prefectora1) and federal (or national) agricultural experiment 
stations--obtain their resources in the political market place and allocate 
their resources through bureaucratic mechanisms. The success of the theory 
of induced technical change gives rise, therefore, to the need for a more 
careful consideration of the sources of institutional innovation and design. 
In this paper we 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. We also 
consider the impact of advances in social science knowledge and of cultural 
endowments on the supply of institutional change. After examining the 
forces that act to shift the demand and supply of institutional innovation 
we then present the elements of a more general model of institutional 
change. The perspective on the role of institutional innovation in the 
process of economic development presented in this paper is much more 
positive than the views that were held by the American institutional school 
or in the recent literature on social choice and collective action 
[Zingler, 1974; Seckler, 1975; Olson, 1982]. 
WHAT IS INSTITUTIONAL INNOVATION? 
Institutions are the rules of a society or of organizations that 
4 
facilitate coordination among people by helping them form expectations which 
each person can reasonably hold in dealing with others. They reflect the 
conventions that have evolved in different societies regarding the behavior 
of individuals and groups relative to their own behavior and the behavior 
1 
of others. 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--'institutions provide assurance respecting the actions 
of others, and give order and stability to expectations in the complex and 
uncertain world of economic relations. ,2 
In order to perform the essential role of forming reasonable expecta-
tions in dealings among people, 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 represents powerful inducements to 
institutional innovation [North and Thomas, 1970; Schultz, 1975]. Institu-
tions that have been efficient in generating growth in the past may, over 
time, come to direct their efforts primarily to protecting the vested 
interests of some of their members by maintaining the status quo and thus 
become obstacles to further economic deve1opment. 3 The growing disequilibria 
in resource allocation due to institutional constraints generated by 
economic growth create opportunities for political entrepreneurs or 
leaders to organize collective action to bring about institutional change. 
Our perspective on the sources of demand for institutional change is 
similar to the traditional Marxian view. 4 Marx considered technological 
s 
change as the primary source of institutional change. Our view is somewhat 
more complex in that we consider that changes in factor endowments and 
product demand are equally important sources of institutional change. Nor 
is our definition of institutional change limited to the dramatic or 
revolutionary changes of the type anticipated by Marx. Rather, we share 
with Lance Davis and Douglass North the view that basic institutions such 
as property rights and markets are more typically altered through the 
cumulation of 'secondary' or incremental institutional changes such as 
modifications in contractual relations or shifts in the boundaries between 
market and non-market activities [Davis and North, 1971:9]. 
There is a supply dimension as well as a demand dimension in institu-
tional change. Collective action leading to changes in the supply of 
institutional innovations involves struggles among various vested interest 
groups. Clearly, the process is much more complex than the clear-cut, 
two-class conflict between the property owners and the propertyless as 
assumed by Marx. In our view, the supply of institutional innovations is 
strongly influenced by the cost of achieving social consensus (or of 
suppressing opposition). How costly a form of institutional change is to 
be accepted in a society depends on the power structure among vested 
interest groups. It also depends critically on cultural tradition and 
ideology, such as nationalism, that make certain institutional arrangements 
more easily accepted than others. 
Advances in knowledge in the social sciences (and in related professions 
such as law, administration, planning, and social service) can reduce the 
cost of institutional change in a somewhat similar manner as advances in the 
natural sciences reduce the cost of technical change. Education, both 
6 
general and technical, that facilitates a better understanding among people 
of their common interests can also reduce the cost of institutional innovation. 
Our insistence that important advances in the understanding of the 
processes of institutional innovation and diffusion can be achieved by 
treating institutional change as endogenous to the economic system represents 
a clear departure from the tradition of modern analytical economics. S 
This does not mean that we abandon analytical economics. On the contrary, 
we try to expand the scope of modern analytical economics by treating 
institutional change as endogenous. 
DEMAND FOR INSTITUTIONAL I~TNOVATION--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 even by evolutionary changes arising out of direct 
contracting by individuals at the level of the community or the firm. In 
other cases, where externalities are involved, substantial political resources 
may have to be brought to bear to organize non-market institutions in order 
to provide for the supply of public goods. 
In this section we illustrate, from the agricultural history of a 
number of countries, how changes in factor endowments, technical change, 
and growth in product demand have induced change in property rights and 
contractual arrangements in order to promote more efficient resource 
allocation through the market. 
The agricultural revolution that occurred in England between the 15th 
and the 19th centuries involved a substantial increase in the productivity 
of land and labor. It was accompanied by the enclosure of open fields 
and the replacement of small peasant cultivators, who held their land 
from manorial lords, by a system in which large farmers used hired labor 
7 
to farm the land they leased from the landlords. The First Enclosure 
Movement, in the 15th and 16th 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 18th century involved conversion of 
communally managed arable land into privately operated units. It is now 
agreed that it 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. When the land was enclosed there 
was a redistribution of income from farmers to landowners and the dis-
equilibrium was reduced or eliminated. 6 
In 19th century Thailand, the opening-up of the nation 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 
for rice production became profitable. The response was a major transforma-
tion of property rights. Traditional rights in human property (corvee and 
slavery) were replaced by more precise private property rights in land 
(fee-simple titles) [Feeny, 1982]. 
In Japan, at the beginning of the feudal Tokugawa period (1603-1867), 
peasants' rights to cropland had been limited to the right to till the soil 
with the obligation to pay a feudal land tax in kind. As the population 
grew, commercialization progressed and irrigation and technology were 
developed to make intensive farming more profitable. Some peasants divided 
8 
their holdings into smaller units and leased them out to ex-servants or 
extended family members. Some accumulated land through mortgaging 
arrangements that made other peasants de facto tenants. As a result of the 
accumulation of illegal leasing and mortgaging practices, peasants' 
property rights in land approximated those of a fee-simple title by the 
end of the Tokugawa period. -These rights were readily converted to the 
modern private-property system in the succeeding Meiji period [Hayami and 
Kikuchi, 1982:28]. 
Research conducted by Yujiro tmyami and Masao Kikuchi in the Philippines 
during the late 1970's has enabled us to examine 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 [Kikuchi and Hayami, 1980; Hayami and Kikuchi, 1982]. The case 
is particularly interesting because 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 micro economic data in a 
village over a period of about 20 years. 
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 
was due to two technical innovations. In 1958, the national irrigation 
system was extended to the village. This permitted double-cropping to 
replace single-cropping, thereby doubling the annual production per hectare 
of rice land. The second major technical change was the introduction in 
the late 1960's of the modern high-yielding varieties. The diffusion of 
modern varieties was accompanied by increased use of fertilizer and 
9 
pesticides and by the adoption of improved cultural 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 of 
the households in the village had no land to cultivate, not even land for 
rent. The average farm size declined from 2.3 to 2.0 hectares. 
The land is farmed primarily by tenants. In 1976, only 1.7 hectares 
of the 108 hectares of cropland in the village were owned by village 
residents. 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, a new agricultural land reform code was passed 
which was designed to break the political power of the traditional landed 
elite and to provide greater incentives to peasant producers of basic 
7 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-1960's 
and. the mid-1970's resulted in a decline in the percentage of land farmed 
under share tenure to 30 percent. 
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 farmed under subtenancy 
arrangements. The number increased from one in 1956, to five in 1966, 
10 
and sixteen in 1976. Subtenancy is illegal under the land reform code. 
The subtenancy arrangements are usually made without the formal consent 
of the landowner. All cases of subtenancy were on land farmed under a 
leasehold arrangement. The most common subtenancy arrangement was 
fifty-fifty sharing of costs and output. 
It was hypothesized that an incentive for the emergence of the subtenancy 
institution was that the rent paid to landlords under the leasehold arrange-
ment was below the equilibrium rent--the level which 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 the highest for the 
land under leasehold tenancy. In contrast, the share-to-land was the 
highest and no surplus was left for the operator who cultivated the land 
under the subtenancy arrangement (Table 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 arrangement. 
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. 
A second institutional change, induced by higher yields and the increase 
in population pressure, has been the emergence of a new pattern of employer-labor 
relationship between farm operators and landless workers. According to the 
traditional system called hunusan, laborers who participated in the 
lnblc 1. F:lctor Shares of Rice Output per Hectare, 1976 l.Jet Season 
Number. Factor sharesa 
of Area Rice Current Land- Sub- Operators' 
Plots (ha) Inputs Total Labor b Surplus Output owner tenancy Capital 
kg/ha - -
Leasehold lnnd 44 67.7 2,889 657 567 0 567 918 337 410 
(100.0)· (22.7) (19.6) (0) (19.6) (31. 8) (11.7) (14.2) 
Share tenancy land 30 29.7 2,749 697 698 0 698 850 288 216 
(100.0) (25.3) (25.4) (0) (25.4) (30.9) (10.5) (7.9) 
Sub-tenancy land 16 9.1 3,447 801 504 80lc 1,305 1,008 346 -13 
I 
;-0 (100.0) (23.2) (14.6) (23.2) (37.8) (29.3) (10.1) (-0.4) i-' I 
a Percentage shares are shown in parentheses. 
b Sum of irrigation fee and paid and/or imputed rentals of carabao, tractor and other machines. 
c Rents to sub-leasors in the case of pledged plots are imputed by applying the interest rate of 40 percent 
crop season (a mode in the interest rate distribution in the village). 
Source: Yujiro Hayami and Masao Kikuchi, Asian Village Economy at the Crossroads: An Economic Approach to 
Institutional Change (Tokyo: University of Tokyo Press, 1981, and Minneapolis: University of 
Minnesota Press, 1982), pp. 111-13. 
12 
harvesting and threshing activity received a one-sixth share of the paddy 
(rough rice) harvest. By 1976, most of the farmers (83 percent) adopted a 
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 designed to reduce the wage rate for harvesting to a level equal 
to the marginal productivity of labor. In the 1950's, 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 
the more abundant supply of labor, the one-sixth share became larger than 
the marginal product of labor in the harvesting operation. 8 
To test the hypothesis that the gamma system was adopted rapidly 
primarily because it represented an institutional innovation that permitted 
farm operators to equate the harvesters' shares of output to the marginal 
productivity of labor, imputed wage costs were compared with the actual 
harvesters' shares (Table 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. 
-13-
TallIe 2. Comparison Bet~.,een the Imputed Value of Harve~;tcrs' Share and 
/ 
and Imputed Cost of Gamma Labor. 
No. of \vorking days of Gamma labor 
a (days/ha) 
\\1eeding 
Harvesting/threshing 
Imputed cost of Gamma labor 
(p/ha)b 
Weeding 
Harvesting/threshing 
(1) Total 
Actual share of harvesters: 
In kind (kg/ha)c 
d (2) Imputed value (P/ha) 
(2) - (1) 
Based on 
employers' 
data 
20.9 
33.6 
167.2 
369.6 
536.8 
504.0 
504.0 
-32.8 
a Includes labor of family members who Horked as Galluna laborers. 
Based on 
employees' 
data 
18.3 
33.6 
146.4 
369.6 
516.0 
549.0 
549.0 
33.0 
b Imputation using market wage rates (daily wage = P8.0 for weeding, PII.O 
for harvesting). 
c One-sixth of output per hectare. 
d Imputation using market prices (1 kg = Pl). 
Source: Yuj iro Hayami and 11<1sao Kikuchi, As ian Vi 11 a~e Economy at the Crossroads: 
An Economic Approar.h to Institutional Ch:mge (Tokyo: University of Tokyo 
Pres~, 198L and Minneapolis: University of Minnesota Press, 1982), p. 121. 
14 
Efficiency and equity implications 
It is important to recognize that subtenancy and gamma contracts 
were the institutional innovations to facilitate more efficient resource 
allocations through voluntary agreements by assigning more complet~ private 
property rights. The land reform laws gave tenants strong protection of 
their tenancy rights with the result that a part of land property rights, 
which is the right to continue tilling the soil at a rent lower than the 
marginal product of land, was assigned to tenant operators. But the laws 
prohibited tenants from renting their land to someone else who might 
utilize it more efficiently, when they become elderly or found more profitable 
off-farm employment, for example. Subtenancy was developed to reduce such 
inefficiency due to the institutional rigidity in the land rental market 
based on the land reform programs. Likewise, the gamma system was developed 
to counteract the institutional rigidity in the labor market based on the 
traditional custom in the rural community in the form of a fixed harvester's 
share. 
It might appear that these institutional innovations increased effi-
ciency at the expense of equity. But, if the subtenancy system had not 
been developed, the route would have been closed for some of the landless 
laborers to become farm operators and use their entrepreneurial abilities 
more profitably. If the implicit wage rate for harvesting work had been 
raised in the absence of the gamma contract, it might have encouraged 
mechanization in threshing and thereby reduced employment and labor earnings. 
It must be recognized that the institutional innovations to develop more 
efficient market by assigning more complete private property rights do 
not necessarily impair equity, as is often argued by Marxist and populist 
critiques against private market institutions. 
15 
In the case reviewed here the induced innovation process leading toward 
the establishment of equilibrium in factor markets occurred very rapidly 
in spite of the fact that many of the transactions--between landlords, 
tenants, and laborers--were less than fully monetized. Informal contractual 
arrangements or agreements were utilized. The subleasing and the gamma 
labor contract evolved without the mobilization of substantial political 
activity or bureaucratic effort. Indeed, the subleasing arrangement 
evolved in spite of legal prohibition. Where substantial political and 
bureaucratic resources must be mobilized to bring about technical or 
institutional change, the changes occur much more slowly, as in the cases 
of the English enclosure movements and the Thai and Japanese property rights 
cases referred to at the beginning of this section. 
THE DEMAND FOR INSTITUTIONAL INNOVATION--NON-MARKET 
INSTITUTIONS FOR THE SUPPLY OF PUBLIC GOODS 
The examples of institutional change advanced in the previous section, 
such as the Enclosure in England and the evolution of private property 
rights in land in Japan and Thailand, have contributed to the development 
of a more efficient market system. Institutional changes of this type are 
profitable for society only if the costs involved in the assignment and 
prot~ction of rights are smaller than the gains from better resource 
allocation. If those costs are very high, it may be necessary to design 
non-market institutions in order to achieve more efficient resource 
allocation. 9 
For example, in Japan, although the system of private property rights 
was developed on cropland during the pre-modern period, communal ownership 
at the village level permitted open access to large areas of wild and forest 
16 
land which were utilized for the collection of firewood, leaves, and wild 
grasses to fertilize rice fields. However, over time more detailed common 
property rules were stipulated for the use of communal land in order to 
h . 10 prevent resource ex aust1on. 
Detailed stipulations of the time and place of utilization 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 much more costly to demarcate and partition 
wild and forest land than cropland among individuals and to enforce 
exclusive use. Any villager's use of communal land involves externality. 
For example, his collection of firewood reduces the availability of the 
firewood for other villagers. If property rights are not assigned, there 
may be only limited incentive for resource conservation. This is not a 
serious problem if the resource that is subject to open access is abundant 
relative to population. However, as population pressure begins to rise, 
a common understanding regarding appropriate use, reinforced by social 
sanctions, may act to limit excessive exploitation. But, as population 
growth continues to press against limited land resources and the market 
value of the resource product rises, it becomes necessary to impose more 
formal regulations regarding the access of individual villagers to 
communal land. 
Group action to supply public goods, such as the maintenance of communal 
land, may work effectively if the size of group involved is small, as in 
the case of a village community. However, if a large number of people are 
involved in the use of a public good, as in the case of marine fisheries, 
17 
it is more difficult to regulate their resource use or to prevent free 
riders by means of voluntary agreements. ll Action by a higher authority 
with coercive power, such as government, may be required to limit free 
riding. 
The 'socialization' of agricultural research is common not only in 
socialist economies but also in market economies [Hayami and Yamada, 1975: 
224-49]. This can be explained by the failure of the market in allocating 
resources efficiently for the supply of public goods for a large, unidentifiable 
clientele group. New information or knowledge resulting from research is 
typically endowed with the attributes of a public good characterized by 
nonrivalness or jointness in supply and utilization, and nonexcludability 
12 
or external economies. 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 utilization 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. However, present institu-
tional arrangements are such that much information resulting from basic 
research is nonexcludable. This is the major reason why it has been 
necessary to establish nonprofit institutions to advance basic scientific 
13 knowledge. 
A unique aspect of agricultural research, particularly that directed 
to advancing biological technology, is that many of the products of 
research--even in the applied area--are characterized by nonexcludability. 
Protection by patent laws is either unavailable or inadequate. The nature 
18 
of agricultural production to be conducted would make it difficult to 
restrict information about new technology or practices. Furthermore, even 
the largest farms are relatively small units and would not be 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. 14 
Another important attribute of the research production function is that 
it has a stochastic form. Research, by nature, is characterized by risk 
and uncertainty. Success in a research project is like hitting a 
'successful oil well.' Any number of dry holes may be bored before the 
successful one is found. Richard Nelson has pointed out that this stochastic 
nature of the research production function, which is especially strortg in 
the case ot basic research, contributes to the failure of the market in 
attaining optimum resource allocation over time: 
'The very large variance of the profit probability distribution 
from a basic research project will tend to cause a risk-avoiding 
firm, without the economic resources to spread the risk by running 
a number of basic-research projects at once, to value a basic-research 
project at significantly less than its expected profitability and 
hence, .•. at less than its social value' [Nelson, 1959:3041. 
The public-good attributes of the agricultural research product together 
with the stochastic nature of the research production function make public 
support of agricultural research socially desirable. It does not necessarily 
follow, however, that agricultural research should be conducted in govern-
mental institutions financed by tax revenue. The social benefit produced 
19 
by agricultural research can be measured as the sum of increases in 
consumers' and producers' surpluses due to the downward shift in the supply 
function of an agricultural product. If the benefit consists primarily 
of producers' surplus, agricultural research may be left to the cooperative 
activities of agricultural producers (i.e., to the activities of 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. 
However, most agricultural commodities are produced by a number of 
small producers. Under these conditions voluntary cooperation to support 
research would be very costly to organize. Furthermore, most agricultural-
commodities, except those intended for export, are characterized by low price 
elasticity of demand. As a result, a major share of the social benefit 
produced by research tends to be transmitted to consumers through lower 
market prices. In such a situation the cost of agricultural research should 
be borne by the general public. 
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 those areas of mechanical technology that 
are adequately protected by patents and to those areas of biological 
technology where the results can be protected by 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 researoh, especially 
20 
in the biological sciences, can be considered a major institutional innovation 
designed to offset what would otherwise represent a serious distortion in 
the allocation of research resources. 
THE SUPPLY OF INSTITUTIONAL INNOVATION 
We have identified the disequilibria in economic relationships asso-
ciated with economic growth, such as technical change leading to the genera-
tion of new income streams and changes in relative factor endowments, as 
important sources bf demand for institutional change. But the sources of 
supply of institutional innovation are less well understood. The factors 
that reduce the cost of institutional innovation have not been widely 
studied by economists or by other social scientists. 
In the Philippines village case discussed earlier, changes in tenure 
and labor market institutions were supplied, in response to the changes in 
demand generated by changing factor endowments and new income streams, 
through the individual and joint decisions of owner-cultivators, tenants and 
laborers. But even at this level it was necessary for gains to the innovators 
to be large enough to offset the risk of ignoring the land reform prohibitions 
against subleasing and the social costs involved in changing traditional 
harvest-sharing arrangements. While mobilization of substantial political 
r-esources was not required to introduce and extend the new land and labor 
market institutions, the distribution of political resources within the village 
did influence the initiation and diffusion of the institutional innovations. 
The supply of major institutional innovations necessarily involves the 
mobilization of substantial political resources by political entrepreneurs 
and innovators. It is useful to think in terms of a supply schedule of 
institutional innovation that is determined by the marginal cost schedule 
21 
facing political entrepreneurs as they attempt to design new institutions 
and resolve the conflicts among various vested interest groups (or suppression 
of opposition when necessary). We hypothesize that institutional innovations 
will be suppl~ed if the expected return from the innovation that accrues to 
the political entrepreneurs exceeds the marginal cost of mobilizing the 
resources necessary to introduce the innovation. To the extent that the 
private return to the political entrepreneurs is different from the social 
return, the institutional innovation will not be supplied at a socially 
. 1 1 15 optl.mum eve. 
Thus, the supply of institutional innovation depends critically on the 
power structure or balance among vested interest groups in a society. If 
the power balance is such that the political entrepreneurs' efforts to 
introduce an institutional innovation with a high rate of social return are 
adequately rewarded by greater prestige and stronger political support, a 
socially desirable institutional innovation may occur. However, if the 
institutional innovation is expected to result in a loss to a dominant 
political block, the innovation may not be forthcoming even if it is expected 
to produce a large net gain to society as a whole. And socially undesirable 
institutional innovations may occur if the returns to the entrepreneur or the 
inte~est group exceed the gains to society [Tullock, 1967; Krueger, 1974; 
Tollison, 1982]. 
The failure of many developing countries to institutionalize the 
agricultural research capacity needed to take advantage of the large gains 
from relatively modest investments in technical change may be due, in part, 
to the divergence between social returns and the private returns to political 
entrepreneurs. In the mid-1920's, for example, agricultural development in 
22 
Argentina appeared to be proceeding along a path roughly comparable to that 
of the United States. Mechanization of crop production lagged slightly 
behind that in the United States. Grain yields per hectare averaged slightly 
higher than in the United States. In contrast to the United States, however, 
output and yields in Argentina remained relatively stagnant between the 
mid-1920's and the mid-1970's. It was not until the late 1970's that 
Argentina began to realize significant gains in agricultural productivity. 
Part of this lag in Argentine agricultural development was due to the dis-
ruption of export markets in the 1930's and 1940's. Students of Argentine 
development have pointed to the political dominance of the landed aristocracy, 
to the rising tensions between urban and rural interests, and to inappropriate 
domestic policies toward agriculture [de Janvry, 1973; Smith, 1969, 1974;:~eavallo 
and Mundlak, 1982]. The Argentine case would seem to represent a case 
where the bias in the distribution of political and economic resources 
imposed exceptionally costly delays in the institutional innovations needed 
to take advantage of the relatively inexpensive sources of growth that 
technical change in agriculture could have made available. 
Cultural endowments, including religion and ideology, exert a strong 
influence on the supply of institutional innovation. They make some forms 
of institutional change less costly to establish and impose severe costs on 
others. For example, the traditional moral obligation in the Japanese village 
community to cooperate in joint communal infrastructure maintenance has made 
it less costly to implement rural development programs than in societies where 
such traditions do not prevail. These activities had their origin in the 
feudal organization of rural communities in the pre-Meiji period. But 
practices such as maintenance of village and agricultural roads and of 
23 
irrigation and drainage ditches through joint activities in which all 
families contribute labor were still practiced in well over half of the 
hamlets in Japan as recently as 1970 [Ishikawa, 1981]. The traditional 
patterns of cooperation have represented an important cultural resource on 
which to erect modern forms of cooperative marketing and joint farming 
activities. Similar cultural resources are not available in South Asian 
villages where, for example, the cast structure inhibits cooperation and 
encourages specialization. 
Likewise, the aspiration of new ideology may reduce the cost to political 
entrepreneurs of mobilizing collective action for institutional change. For 
example, the Jeffersonian concept of agrarian democracy provided ideological 
support for the series of land ordinances culminating in the Homestead Act 
of 1862, which established the legal framework designed to encourage an 
owner-operator system of agriculture in the American West [Cochrane, 1979: 
41-47, 179-88]. Strong nationalist sentiment in Meiji Japan, reflected in 
slogans such as 'A Wealthy Nation and Strong Army' (Fukoku Kyohei), helped 
mobilize the resources needed for the establishment of vocational schools 
and agricultural and industrial experiment stations [Hayami, et al., 1981]. 
In China, communist ideology, reinforced by the lessons learned during the 
guer~ila period in Yenan, inspired the mobilization of communal resources 
to build irrigation systems and other forms of social overhead capital 
[Schran, 1975]. Thus, ideology can be a critical resource for political 
entrepreneurs and an important factor affecting the supply of institutional 
innovations. 
Advances in social sciences that improve knowledge relevant to the 
design of institutional innovations that are capable of generating new 
24 
income streams or that reduce the cost of conflict resolution act to shift 
the supply of institutional change to the right. Throughout history, 
improvements in institutional performance have occurred primarily through 
the slow accumulation of successful precedent or as by-products of expertise 
and experience. Institutional change was generated through the process of 
trial and error much in the sa~e manner that technical change was generated 
prior to the invention of the research university, the agricultural 
experiment station, or the industrial research laboratory. With the 
institutionalization of research in the social sciences and related pro-
fessions the process of institutional innovation has begun to proceed much 
more efficiently; it is becoming increasingly possible to substitute social 
science knowledge and analytical skill for the more expensive process of 
learning by trial and error. 
The research that led to advances in our understanding of the production 
and consumption of rural households in less developed countries represents 
an important example of the contribution of advances in social science 
knowledge to the design of more efficient institutions [Schultz, 1964; 
Ner1ove, 1974; Binswanger, Evenson, F1orencio, and White, 1981]. In a 
number of countries this research has led to the abandonment of policies 
that viewed peasant households as unresponsive to economic incentives. And 
it has led to the design of policies and institutions to make more productive 
technologies available to peasant producers and to the design of more efficient 
price policies for factors and products. 
Similarly, the diffusion of education designed to raise the intellectual 
level of the general public and to facilitate better understanding of the 
private and social costs of institutional change may reduce the cost to 
25 
political entrepreneurs of introducing socially desirable institutions and 
raise the cost of biasing institutional change in a manner that is costly 
to society. 
TOWARD A MORE COHPLETE MODEL OF INDUCED INNOVATION 
We illustrate, in Figure 1, the elements of a model that maps the 
general equilibrium relationships among resource endowments, cultural 
d h 1 · d· . . 16 en owments, tec no og1es an 1nst1tut10ns. The model goes beyond the 
conventional general equilibrium model in which resource endowments, tech-
nologies, institutions, and culture (conventionally designated as tastes) 
are given. 17 In the study of long-term social and economic change the 
relationships among the several variables must be treated as recursive. 
The formal micro economic models that are employed to analyze the supply and 
demand for technical and institutional change can be thought of as 'nested' 
within the general equilibrium framework of Figure 1. 
One advantage of the 'pattern model' outlined in Figure 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 that it is useful in identifying the 
model 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. 
Resource 
Endowments 
r 
f 
I 
\ 
-7.6-
Technology 
e c 
I 
F 
I 
/1 C 
\l~~ -0-
---~ 
Cultural 
Endowments 
Figure 1. 
~ __ V Institutions 
--- -d-
Interrelationships Between Changes in Resource Endowments, 
Cultural Endowments, Technology and Institutions. 
27 
In his book, Oriental Despotism, Karl Wittfogel views the irrigation 
technology used in wet rice cultivation in East Asia as determining political 
organization [Wittfogel, 1957]. In terms of Figure 1 his primary emphasis 
was on the impact of resource endowments on institutions (C) and (B). 
A serious misunderstanding can be observed in contemporary neo-Marxian 
critiques of the 'green revolution'. These criticisms have focused 
attention almost entirely on the impact of technical change on labor and 
land tenure relations. Both the radical and populist critics have emphasized 
relation (B). But they have tended to ignore relationships (A) and (c).18 
This has led to repeated failure to identify effectively 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 
was illustrated in the work by Hayami and Kikuchi, discussed earlier in this 
paper, on the impact of both technical change and population growth on 
changes in land tenure and labor market relationships in the Philippines. 
Armen Alchian and Harold Demsetz identify a primary function of property 
rights as guiding incentives to achieve greater internalization of externali-
ties. They consider that the clear specification of property rights reduces 
transaction costs in the face of growing competition for the use of scarce 
resources as a result of population growth and/or growth in product demand 
[Demsetz, 1967; Alchian and Demsetz, 1973]. 
North and Thomas, building on the Alchian-Demsetz paradigm, attempted 
to explain the economic growth of Western Europe between 900 and 1700 
. '1 . f h' ... 19 pr~mar~ y ~n terms 0 c anges ~n property ~nst~tut~ons. During the 11th 
and 13th centuries the pressure of population against increasingly scarce 
land resources induced innovations in property rights that in turn created 
28 
profitable opportunities for the generation and adoption of labor-intensive 
technical changes in agriculture. The population decline in the 14th and 
15th centuries was viewed as a primary factor leading to the demise of 
feudalism and the rise of the national state (line C). These institutional 
changes in turn opened up new possibilities for economies of scale in 
nonagricultural production and in trade (line b). 
In a more recent work Mancur Olson has emphasized the proliferation of 
'i f' d l' 20 1nstitut ons as a source 0 econom1C ec 1ne. 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 agricul-
tural producers is more likely to exert political pressure for growth-oriented 
policies that will enable its members to obtain a larger share of a larger 
national product than a smaller organization that represents the interests 
of the producers of a single commodity. Small organizations representing 
narrow interest groups are more likely to pursue the interests of their 
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 an organization 
~epresenting 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 more devisive. They slow down the adoption of new technologies (line b) 
29 
and limit the capacity to reallocate resources (line c). The effect is 
to slow down economic growth or in some cases initiate a period of economic 
decline. 
What are the implications of the theory of institutional innovation 
outlined in this paper for the research agenda on the economics of 
institutional change? In our research on the direction and rate of technical 
change we were able to advance significantly our knowledge by treating 
technical change as endogenous--as induced primarily by changes in relative 
resource endowments and the growth of demand. We have also attempted to 
develop a theory of induced institutional innovation in which we treat 
institutional innovation as endogenous. There is now a significant body of 
evidence that suggests that substantial new insights on institutional 
innovation and diffusion can be obtained by treating institutional change 
as an economic response to changes in resource endowments and technical 
change. 
We also insist on the potential significance of cultural endowments, 
including the factors that economists typically conceal under the rubric of 
tastes and that political scientists include under ideology. But our 
capacity to develop rigorous 
relative significance of the 
empirical tests capab,~of identifying the 
relationships betweeniNtultural endowments and 
the other elements of the model outlined in Figure 1 is quite unsatisfactory. 
Until our colleagues in the other social sciences provide us with more 
helpful analytical tools, we are forced to adhere to a strategy that focuses 
primarily on the interactions between resource endowments, technical change, 
and institutional change. The strategy suggested here does have the clear 
advantage of allowing us to explore how far a strategy based on the rather 
straightforward extension of standard microeconomic theory will take us in 
the analysis of both technical and institutional change. 
30 
NOTES 
1. There is considerable disagreement regarding the meaning of the term 
institution. A distinction is often made between the concepts of 
institution and organization. We find the broad view which includes 
both concepts most useful for our purpose. This is consistent with the 
view expressed by both Commons [1950:24] and Knight [1952:51]. Our 
definition also encompasses the classification employed by Davis and 
North [1971:8-9]. We employ the more inclusive definition in order 
to be able to consider changes in the rules or conventions that 
govern behavior (a) within economic units such as families, firms and 
bureaucracies, (b) among economic units as in the cases of the rules 
that govern market relationships, and (c) between economic units and 
their environment, as in the case of the relationship between a firm 
and a regulatory agency. 
2. See Runge [1981b:xv]. Formal analysis of the role of institutions 
in providing assurance of stability in economic relationships emerged 
from dissatisfaction with the implications of the assumption of strict 
dominance of individual strategy in modern welfare economics. See 
Sen [1967] and Runge [198la]. In a less formal treatment, North 
argues, in a chapter on 'Ideology and the Free Rider Problem', that 
shared ideological and ethical perspectives provide assurance that is 
lacking in models built on the dominance of individual strategies 
[1981:45-58]. 
3. 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 the central theme in Olson [1982:74]. 
31 
4. '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 super-
structure is more or less rapidly transformed' [Marx, 1913:11-12]. 
For a discussion of the role of technology in Marxian thought see 
Rosenberg [1982:34-54]. 
5. The orthodox view of a generation ago was expressed by Samuelson 
[1948:221-22], 'The auxiliary [institutional] constraints imposed upon 
the variables are not themselves the proper subject of welfare economics 
but must be taken as given.' Contrast this with the more recent 
statement by Schotter [1981:6], 'We view welfare economics as a 
study ... that ranks the system of rules which dictate social 
behavior.' 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 (a) the theory of property rights, (b) 
the theory of economic regulation, (c) the theory of interest group 
rent seeking, (d) the liberal-pluralist theories of government, and 
(e) the neo-Marxian theories of the state. In the property rights 
theories the 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 
32 
bureaucratic choice processes; and the theory of the state attempts to 
incorporate electoral, legislative choice, and bureaucratic choice 
processes. For a review and criticism see Rausser, Lichtenberg, and 
Lattimore [1982]. 
6. There has been a continuing debate among students of English agricultural 
history about whether the higher rents that landowners received after 
enclosure was (a) because enclosed farming was more efficient than 
open field farming, or (b) because enclosures redistributed income from 
farmers to landowners. See Chambers and Mingay [1966], Dahlman [1980], 
and Allen [1982]. 
7. Although the passage and implementation of the Land Reform Code of 1963 
was exogenous to the economy of the village, the land reform of the 
1960's has been interpreted as the result of efforts by an emerging 
industrial elite to break simultaneously the political power of the 
more conservative land-owning elite and to provide incentives to 
peasant producers to respond to the rapid growth in demand for 
marketable surpluses of wage goods, primarily rice and maize, needed 
to sustain rapid urban industrial development. Thus, the Land Reform 
Code can be viewed as an institutional innovation designed to facilitate 
realization of the opportunities for economic growth that could be 
realized through rapid urban industrial development. See Ruttan [1969]. 
8. Real wages for agricultural labor declined significantly between the 
mid-1950's and the mid-1960's in the Philippines. See Khan [1977]. 
Thus, while we cannot be certain that the labor market was in equilibrium 
in the 1950's, it is clear that the degree of disequilibrium widened, 
as a result of both higher yields and lower wage rates, prior to the 
introduction and diffusion of the gamma system. 
33 
9. Harold Demsetz has pointed out that the relative costs of using market 
and political institutions is rarely given explicit consideration in 
the literature on market failure. An appropriate way of interpreting 
the 'public goods' vs. 'private goods' issue is to ask whether the 
costs.'of providing a market are too high relative to the cost of non-market 
alternatives. [1964]. A similar point is made by Leonid Hurwicz [1972]. 
10. For 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 was elaborated in Demsetz [1967] 
and Alchian and Demsetz [1973]. 
11. See Olson [1968]. 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 implied by 
Olson's model. See Runge [198lb:189-99] and North [1981:54]. North 
notes that 'the premium necessary to induce people to become free 
riders is positively correlated with the perceived legitimacy of the 
existing institution.' 
12. For a characterization of the nonrivalness and nonexcludability 
attributes of public goods see Samuelson [1954; 1955; 1958] and 
Musgrave [1959]. 
34 
13. Nonrivalness is an essential attribute of information. The use of 
information about a new farming practice (contour ploughing, for example) 
by a farmer is not hindered by the adoption of the same practice by other 
farmers. There is no capacity limit for its utilization. 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 make a certain kind 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. These arrangements are the 
ones designed to promote more efficient resource allocation through 
market arrangements as discussed in the previous section. 
14. In a number of countries 'breeders' rights' and 'petty patent' legislation 
has induced rapid growth in private sector R&D related to agriculture. 
See Ruttan [1982] and Evenson and Evenson [1983]. 
15. See, for example, Frohlich, Oppenheimer, and Young [1971]. For a 
review and extension of concepts of political entrepreneurship see 
Guttman [1982]. 
16. Fusfeld [1980:33] uses the terms 'pattern' or 'Gestalt' model to 
describe a form of analysis that links the elements of a general 
pattern together by logical connections. The recursive multi-causal 
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 phenomenon 
under investigation.' 
35 
17. 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. Our use of the term culture is 
consistent with the definition suggested by Leslie A. White, 'When 
things and events are considered in the context of their relation to 
the human organism, they constitute behavior; when they are con-
sidered • • • in their relationship to one another, they become 
culture' [White, 1974:1158]. We 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. 
18. 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, 6lJ. 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 the major innovation of the 'cultural materialism' 
school of anthropology. See Harris [1979]. 
19. See North and Thomas [1970:l-l7a; 1973]. For a critical perspective on 
the North-Thomas model see Field [1981]. Field is critical of the 
attempt by North and Thomas to treat institutional change as endogenous. 
20. See Olson [1982]. For a review of the Olson work see North [1983:163-64]. 
36 
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