Explanatory Power of the Induced
Institutional Innovation Theory
Lechuan Huang
Department of Economic History,
London School of Economics and Political Science,
London,
United Kingdom,
WC2A 2AE
l.huang1@lse.ac.uk
November 6, 2007
Abstract
As a pattern of thought, North, and other new institutionalist
economists use the theory of induced institutional innovation to ex-
plain the change and evolution of institutions. In other words, in-
stitutions should be developed in a way comparable to the forming
of equilibrium in economic markets. This essay uses a chain model
to analyse the explanatory power of this theory. The analysis distin-
guishes between institutional innovation and change. It finds that for
successful theoretical application to institutional change, favourable
preconditions, a shock that creates market disequilibrium, rational
agents that respond to the shock quickly, and a fairly competitive po-
litical market are required. However, for institutional innovation, the
theory is only relevant in that change is a necessary condition.
1 Introduction
It is intuitive to apply the market mechanism to the evolution of institutions,
for new institutionalist economists still base their theory on the, if somewhat
limited, interactions between rational agents.
The theory of induced institutional innovation (henceforth, the theory)
bases itself on that assumption. However, there is a danger, as North himself
1
has realized, that the very market in question is a political one, which is not
as efficient as the economic market (see North, 1996, p.345). Hence, there is
no promise that institutional innovation will be induced as expected.
This article tries to gauge the explanatory power of the theory by building
a chain model. Through analysis of each link in the chain, the favourable
factors for the successful application of the theory can be identified.
2 The Model
Our model is a two-step one. Step one reduces institutional innovation to
institutional change. This is necessary because there are some nuances be-
twee