A win–win path for institutional change

Abstract

Institutional change is a response to socioeconomic pressures caused by resource scarcity, population growth, cultural change, and economic inefficiency. Historical evidence shows that the unequitable resource redistribution among groups caused by institutional change can indirectly reduce income, particularly when it leads to civil conflicts. A more equitable and effective approach to institutional change would seek win–win solutions. To examine this possibility, I review historical examples of institutional change in China to show how gradual institutional change that lets all stakeholders share the economic benefits is the most successful path. Therefore, innovation to replace or modify old institutions and equitably increase economic growth will be a key approach. This win–win approach requires persuasion, compromise, demonstration projects, competition, and embracing institutional diversity. Increased economic benefits come from economic innovation and encouragement of stakeholders to participate in institutional change, but require nurturing of new social groups that will drive the change process.

Keywords

Compensation economic institutions ideology social costs new social groups trial-and-error

Introduction

Human society relies heavily on its institutions to resolve conflicts over the use of scarce resources and alleviate other constraints (Alchian and Demsetz, 1973; Argandoña, 2004; North, 1971). To manage the associated complexity and solve complex problems, integrated responses tend to involve networks and partnerships among various levels of government, the private sector, and civil society (Berkes, 2007; Mabogunje, 2000). However, differences in the power held by these groups can create barriers to establishing such networks and partnerships. In particular, some stakeholders resist change when economic objectives may compromise social objectives or undermine the benefits they receive (Berkes, 2007). In addition, such changes alter both the allocation of economic resources and political power structures (Bridgman, 2008). If a change is perceived as likely to harm a group, that group will allocate resources to prevent the change. The more resources a group allocates to prevent a change or to direct it in a different direction, the smaller the net benefits the group will gain (Goldberg, 1974). Thus, social evolution often results from intense political and social conﬂict, and sometimes even revolutions (Acemoglu et al., 2011), and finding a more efficient means of institutional change is vital for an efficient socioeconomic system (Argandoña, 2004).

Institutional change commonly involves both horizontal interactions among institutions at the same hierarchical level and vertical interactions between different levels within an organization (Berkes, 2007). The complexity of socioeconomic systems encourages politicians to seek simple solutions, such as rapidly changing an institution through the application of governmental power, and information asymmetry gives them an advantage in imposing such solutions on the public; however, such changes often have adverse effects, particularly when they lead to resistance by citizens. Currently, we lack sufficient understanding of these issues to objectively and rationally harmonize the needs of civil society, industry, and government, making the outcomes uncertain (Ruttan, 1999). The problem of finding compatible incentives for all stakeholders has not been solved, even at a theoretical level (Acemoglu et al., 2011; Bridgman, 2008). Therefore, we must develop a theoretical framework that encompasses traditional economic models but broadens their scope to include an explanation of how institutions form, evolve, and degrade. This increased understanding would make it feasible to attempt innovations that lead to more equitable institutional change. Unfortunately, there is currently no way to ensure discovery of the optimal changes to an institution. Furthermore, inefficiencies that result from competing objectives make the process unnecessarily difficult and expensive.

An examination of historical evidence suggests that the redistribution of resources among groups that is caused by institutional change can indirectly reduce income by causing civil conflicts and even war, thereby increasing the cost of the change or even diverting resources to the military (Bridgman, 2008). Therefore, achieving successful and equitable institutional change without compromising economic development or social stability requires a different approach: one that serves the needs of all stakeholders, thereby avoiding conflict. In the present paper, I propose an approach to institutional change based on innovation and seeking a win–win path. This approach accounts for the attitude of managers towards risk and uncertainty, the ability to develop institutional and human capabilities and to access complementary assets, and a favorable regulatory environment. To determine whether institutional change can lead to a socially optimal solution, I discuss institutional change from the perspective of Chinese history (because readers are likely to be familiar with Western examples) and illustrate how institutional change can become more equitable. Based on this analysis, I propose recommendations for policy changes and future research.

A win–win path to institutional change

Changing economic institutions

The human desire to pursue personal economic benefits must be made more compatible with the need to solve problems such as population growth and scarcity of natural resources, creating a need for institutional change. These economic benefits may be in the form of wages paid to compensate for work, rents (incomes provided by the use of some property), or a share of the output of an activity; may be received in money or in kind; and may be used directly or exchanged in various kinds of market to obtain a desired bundle of consumption goods (North and Thomas, 1971). As the number of options for receiving and exchanging these benefits has grown, traditional institutional arrangements such as shared labor or barter have lost their advantage due to the lower transaction costs of newer institutions (Schneiberg, 2005). Institutional arrangements have also changed to take advantage of these new mechanisms for obtaining and exchanging value and benefits from the associated productivity improvements. Furthermore, new institutions will arise when the marginal cost of providing protection for assets and revenues exceeds the marginal increase in production that results from increasing productivity (North, 1971).

Technological change and institutional innovation are interdependent: new technology creates disequilibria that make it profitable to modify old institutions or adopt innovative institutional arrangements (Beddoe et al., 2009). Institutional change also arises in response to the availability of new resources or the development of new industries permitted by scientific or technological innovation. However, old institutions are generally retained until the benefits from the new institution exceed their benefits. The old institutions may instead evolve if those who preserve them can learn from the new system. For example, as iron farm tools became more common, agricultural work became easier, providing more leisure time after a peasant's work was complete. Another contemporaneous example occurred when manorial farmland could no longer feed the increasing population, causing many peasants to claim their own land outside the manor's holdings. During China's Zhou Dynasty (1046 to 221 BC), farmland was divided into units similar to European manors that were managed by nobles; each unit was divided into a nine-cell grid, resembling the # character. The outer cells belonged to individual families; the inner cell was farmed by these families, but the produce belonged to a noble, and the noble’s land was managed first (http://en.wikipedia.org/wiki/Well-field_system).

The new social institutions that arose in the West when peasants claimed their own land emerged beside the old manorial system, and eventually replaced the manorial system due to their greater efficiency. However, the growth of the new system came at a cost to the old system; owners of the manors required additional military support to protect their land and stop the spread of the new system. This approach was imperfect because it was too expensive and the peasants could leave the manor and find land elsewhere. A similar phenomenon occurred in China, and the central government eventually accepted the greater efficiency of the new system, leading to the Shang Yang reform in 361 BC (Wang, 2012), which devolved much power from the nobles to the peasants (North and Thomas, 1971; Sun, 2004).

History often repeats, as we saw in China 30 years ago. The “class struggle strategy” (Zhao, 2006) accompanied a 72.2% population increase from 1949 to 1976, from 541 million to 933 million. In 1976, Chinese farmers were among the poorest in world, with a net income of only 131 RMB—about US$21 in today's dollars (China Statistics Bureau, 2009). Agricultural productivity did not increase equally rapidly, so to solve the resulting hunger crisis, many farmers in Xiaogang Village, Anhui Province, signed an illegal agreement in December 1978 to divide the village’s common farmland for planting by individual families (Figure 1). As a result, the production of grain and edible oilseeds increased to 4 and 19 times the 1978 level, respectively, in 1979 (Yi, 2009). This village-level innovation represented a major institutional change that both improved efficiency and added an individual component within Mao’s communal agro-industry system. Some authorities trace China's modern reforms back to this act of rebellion (http://en.wikipedia.org/wiki/Xiaogang,_Anhui). Having accepted the implications of the Xiaogang example, the government implemented economic reforms, including tax decreases, to stimulate specific industries: household electrical appliances in the 1980s (Whyte, 2009), cars and real-estate in the 1990s, the service and cultural industry in the 2000s, and the travel and aerospace industries in the 2010s. Since 1978, the production of televisions, air conditioners, residential (commercial) buildings, and cars increased by 23 187, 695 724, 30, and 869 times, respectively (Figure 2). Chinese statistics reveal that the number of privately held enterprises increased from nearly zero in 1978 to 5.8 million in 2011, amounting to 79% of the total number of enterprises in China (China Statistics Bureau, 2012). Simultaneously, the numbers of employees of private enterprises and self-employed individuals increased from 0.15 million (both categories combined) in 1978 to 121.4 million in 2011 (Figure 2). These values represent 0.002 and 1.93 times (respectively) the number of employees working for state-owned enterprises (China Statistics Bureau, 2012). Such institutional reforms have helped China's real gross domestic product (GDP) grow by an average of ∼10% annually, from 0.36 × 10¹² RMB in 1978 to 47.29 × 10¹² RMB in 2011 (China Statistics Bureau, 2012). This privatization has been surprisingly rapid and has been accompanied by smooth institutional change (Zhang, 2012).

Figure 1.

Photograph of the historical agreement signed by the farmers of Xiaogang Village, Anhui Province, in 1978. The agreement declares that the householders will partition the village’s common farmland among the families. If the government imprisoned or killed the farmers for this illegal agreement, the village's leaders agreed that the community would feed their children until age 18. Source: Yi (2009).

Figure 2.

Production of televisions, air conditioners, and homes, car ownership, and number of employees of private-sector enterprises (private enterprises and self-employed individuals), from 1978 to 2011. Source: China Statistics Bureau (2012).

This example shows how the appearance and subsequent encouragement of new approaches and new industries led to institutional change that redistributed the new economic benefits and political power among social groups, though sometimes at the expense of older groups that benefited from the old system. Such changes violate, modify, or otherwise bypass existing institutional arrangements and place growing pressure on the older institutions. These changes reflect differences in relative bargaining strength or decreased transaction costs, which increase the income of both sides of a transaction in unpredictable ways. Political institutional change has been slower, although China’s economic institutions began changing from the centrally planned economy of the 1980s to a socialist market economy in the 1990s. Although this transition has been relatively smooth, it has been accompanied by some undesirable side-effects, such as environmental deterioration, excessively rapid urbanization, a growing income disparity between urban and rural residents, and corrupt practices such as the sale of land occupied by citizens to generate income for local governments (Cao et al., 2009a). The redistribution of benefits that has followed these changes has often been inefficient because it generated what seem to be inescapable conflicts between winners and losers (Zheng et al., 2014).

Equitable change of political institutions

Economic, social, and technological changes produce disequilibrium in a system, resulting in opportunities for profit and institutional innovation that may ultimately change the overall institutional environment (North, 1971). There are costs to both institutional change and institutional stasis, although change often has such high benefits that it cannot be resisted for long. When conflicts arise over fundamental institutions, groups that achieve power tend to codify the new rules in a “constitutional” document that becomes difficult to alter (North and Thomas, 1971). When new industrial and social groups form, the authorities responsible for current institutions initially try to resist them, as in the abovementioned example of the Shang Yang reform.

The new institutional arrangements resulting from this reform gave the peasants most of the grain they produced except for a small amount they paid to the land's owners (about 10% of the produce) in compensation for use of the land and individual property rights that let the peasants conduct a business or even lease the land. This represents an example of a win–win institutional change because the peasants obtained property rights and most of the benefits from the land, whereas the noble landowners obtained new tax revenues and eliminated the military cost created by removing peasants from the land. In addition, the Qin Dynasty (originally a small state within the Zhou Dynasty) emerged from this period to become one of the strongest states that remained after the fall of the Zhou Dynasty; the Qin grew strong enough to defeat the other warlords and unify China (Sun, 2004).

To understand the origins of such changes, it is necessary to separate the cumulative pressures responsible for the change from the events that released the pressures and triggered the change through the behavior of political and economic actors. As new socioeconomic groups emerge, fundamental institutions must change to protect their benefits; some new institutions will emerge, and old institutions may adapt in response. Many such institutions arise spontaneously rather than through conscious design. China’s early rural reforms, including the rise of a private sector, were initiated by farmers and unemployed urban residents rather than by the state (Lin, 2002), as in the abovementioned example of Xiaogang Village.

History shows that the institutions of the ruling class change slowly, through gradual modification of conventions that were sanctified by tradition. However, the sum of many minor alterations over generations leads to fundamental change in the institutional environment that governs society (Petr, 1986). This represents a process of adaptation in which a host of secondary institutional developments arise to circumvent previous institutions that are no longer efficient. In feudal England, the cumulative effect was a series of fundamental changes to the laws between the 13th and 17th centuries that eventually permitted, in effect, fee-simple land ownership (North, 1971). However, it was not until the 1920s when new property acts eliminated the language and some lingering elements of the feudal land laws (North and Thomas, 1971). The United States, long seen as a home of democracy, required nearly 200 years after its founding to achieve truly democratic rule by extending the vote to virtually all adults (the Voting Rights Act of 1965), a process initiated by the slavery abolitionists, freed slaves and their descendants, workers, and women who demanded the right to vote (Bowles, 2012). However, China’s government provides a counter-example, having declared no desire to follow the path of western democracy at the 18th National Congress of the Communist Party of China in November 2011 (Zhan, 2012), despite 34 years of successful economic reform. More time will be required for political institutional change to take hold in China.

Competition and spreading of influence abroad

Competition is a fundamental tool for stimulating ownership reform, improving economic efficiency, and reforming private and governmental decisionmaking (Goldberg, 1974; Schneiberg, 2005; Zhao, 2006). For example, the fiscal decentralization that has occurred in China since 1979 has motivated local officials to promote market-oriented growth and run their local economy more like a public corporation (Lin, 2002). Similarly, competition among local governments is a form of market competition that has forced these governments to improve their practices to ensure that local enterprises stayed instead of “voting with their feet” (Zhao, 2006). Local government tax receipts increase with improving economic conditions, providing an incentive to improve these conditions. Therefore, governments must implement “rules of engagement” that motivate their constituents to engage in economic activities (North, 1990).

Authority structures can change both through consensus and through the exercise of power. States that intervene in the affairs of other countries tend to do so repeatedly to promote institutions similar to their own institutions (Krasner, 2011). For example, Pickering and Peceny (2006) identified five United Nations military interventions and three United States military interventions associated with democratization between 1946 and 1996. Such interventions cause discontinuous (radical) changes in local institutions (Mabogunje, 2000). The imposition of new institutions such as democracy sometimes encourages transitions to new institutions. In Germany, Japan, and Italy after Second World War, the victorious democracies essentially imposed democratic institutions as a price for independence of the vanquished nations (Olson, 1993). This is not an isolated example; in the 1300s, Europe was governed by about 500 sovereign “empires, city states, federations of cities, networks of landlords, religious orders, leagues of pirates, warrior bands” (Tilly and Blackwell, 1990), but by the 20th century, fewer than 30 states remained. A good Chinese example is the Qing Dynasty, which united seven major and several minor semi-independent states into what eventually became modern China.

Successful institutional change in Europe led to export of its nation-state model; because this export was often at gunpoint, some states adopted this model as a defensive measure to preserve their own autonomy (Bowles, 2012). The European system of taxation, military recruitment, and borrowing large sums of money allowed nation-states to conduct organized warfare rather than relying on ad hoc requisitioning of food, weapons, soldiers, and animals (Tilly and Blackwell, 1990). However, this approach required a flourishing economy, easily available credit, effective tax collection, and a willingness to serve the nation in time of war. Because successful warfare requires mobilization of a willing or compliant population, the nation-state outcompeted other political institutions by developing a centralized bureaucratic structure capable of maintaining control over the state's territory, mobilizing the necessary resources by taxation and borrowing, and developing a standing army (Spencer, 2010). An equally dramatic process occurred in China between the 5th and 3rd centuries BC, and may also have accounted for emergence of the first states in Mesopotamia, Mesoamerica, Peru, Egypt, and the Indus Valley (Bowles, 2012).

Locked-in institutions and revolutions

Although win–win paths are a commendable goal, they are difficult to attain. Changes in the fundamental institutions of Europe and China significantly redistributed power and wealth, leading to the present situation. In most cases, some groups gained and others lost—or gained less. This is because it is human nature to pursue one's self-interest even when staying within the rules; it is also natural to allocate resources to change the rules to one's own benefit (Goldberg, 1974). When policymakers face multiple options, they typically pick the option that maximizes their personal utility (Zhao, 2006). Policymakers also have an incentive to initiate change in a way that enlists the cooperation of others until the institutional change can be “locked in” (Argandoña, 2004). The distinction between voluntary and governmental associations is more complicated than previously imagined. Governments and any other partial or total “owner” of a society's resources have an incentive to charge monopolistic rents on these resources, which include human labor (Olson, 1993).

“Locking in” certain processes in the form of an institution can considerably increase the cost of subsequent change when the purpose of the institution is to preserve the interests of certain parties rather than achieving collective social goals such as stability, an optimal allocation of resources, or economic efficiency (Goldberg, 1974; North, 1971). This does not prevent institutions from being created or modified to benefit society as a whole, but this will not happen unless the agents of change have a strong incentive to allow or promote this outcome. Institutions control the distribution of resources, leading to power struggles and other forms of conflict; this may improve the greater social good, but can also produce clearly suboptimal results (Argandoña, 2004). Since changes in the rules that govern decisions typically redistribute wealth and political power, we cannot easily predict the outcome of such changes. Furthermore, the response lag between decisions and their impacts varies widely. For example, in Spain, the Mesta (a powerful union of sheep ranchers) acquired sufficient power to move their sheep across anyone's land without paying compensation (North, 1971), greatly slowing the creation of effective rights to private property despite a growing population eager for such rights (North and Thomas, 1971).

New institutions only work if the majority adopts the institution. The origins of phenomena such as the nation-state and benevolent social norms can be found in a combination of conflict between groups and attenuation of the inequalities and conflicts within groups (Bowles, 2012). Although China's development has been successful in recent decades, China has experienced recurring problems with corruption, crony capitalism, and other predictable consequences of heavy state involvement in an economy (Whyte, 2009). When a government chooses to not learn from others, civil conflicts within and between societies (including violent revolution) have historically created conditions for the birth of humanity’s most cherished values and institutions, including democracy, the rule of law, and a social system that encourages aid to others and the avoidance of injustice (Bowles, 2012).

The hypothesis that institutional change follows a J-shaped curve, with a slow initial phase followed by sudden and rapid change that may benefit a minority of stakeholders disproportionally, has been used by governments such as those in Eastern Europe, South America, and Africa (Schneiberg, 2005) to deceive stakeholders about the large benefits produced by institutional change. To limit the government’s power to decide who receives the maximum benefit from institutional change requires a neutral policy-maker—such as China’s successful Economic Reform Committee from 1982 to 1996. Unfortunately, when the Committee was disbanded in 1996 (Du, 2003), China's State Department began developing policies specifically for the benefit of the government. As result, government revenues had increased to 13 times their 1990 level by 2011, versus an increase of only 4.6 times for citizens. The ratio of governmental to civilian revenues increased to 1.5 times its 1996 level by 2011, excluding the effects of inflation. The value of the Gini coefficient (http://en.wikipedia.org/wiki/Gini_coefficient), for which a value of 0 represents perfect equality and 1.0 represents the maximum possible inequality, increased by 120% in China, from 0.25 in 1978 to 0.55 in 2011, giving China one of the world's largest gaps between the poor and the rich (Figure 3; China Statistics Bureau, 2012).

Figure 3.

The changes in government and civilian revenues, in their ratio, and in the Gini coefficient from 1978 to 2011.

A win–win path for institutional change

When an old institution no longer efficiently solves social or economic problems, new institutions become necessary to balance the private and social rates of return. There appear to be few such institutions today, even 40 years after North and Thomas (1971) first described this problem. Therefore, governments should adopt a gradual, cautious approach to institutional change based on a win–win philosophy: by trying to give all stakeholders an opportunity to “win”, conflict and resistance to change decrease, thereby smoothing the road and reducing the cost of change. A determination to steadily push ahead—in Deng Xiaoping's words, to ”cross the river of economic reforms by stepping from stone to stone”—sends a message to both society and the government decisionmakers responsible for implementing policy that everyone’s future depends on making new institutions work so that everyone benefits, rather than smothering them at birth out of fear. I believe this can be accomplished by seeking win–win solutions, such as the ones described in my previous papers (Cao et al., 2009b; Cao, 2012; Xu et al., 2011; Zhong et al., 2013). This is best accomplished by means of several strategies: persuasion, building institutional diversity, seeking compromise, and testing institutions by means of demonstration projects.

Persuasion

It is difficult to predict which potentially productive institutional arrangements will succeed, making it difficult to convince stakeholders to accept a proposed change. To facilitate reform, it is therefore crucial to convince stakeholders that experts have carefully assessed the situation (Heinemann and Tanz, 2008). People with more education about politics tend to care more about what happens and tend to participate more in politics (Goldberg, 1974). Therefore, educating stakeholders is a powerful tool for encouraging their participation in institutional change. However, because experts have often been wrong in the past, other measures (discussed later in this section) are necessary to gain support for a reform.

Many Chinese philosophers, including Laozi (571 to 471 BC), Confucius (551 to 479 BC), Mencius (372 to 289 BC), and Zhuanzi (369 to 286 BC) have debated institutional change with rulers. These debates persuaded many rulers to undertake fundamental institutional reforms, as in the abovementioned Shang Yang agricultural reforms. Similarly, when the focus of China's government policy shifted from class struggle to economic development under Deng Xiaoping, the pragmatic principle of “seeking truth from facts” led to drastic economic reforms after 1978 (Lin, 2002). To change the official ideology against wealth and property ownership that dominated Chinese thought after 1949, Deng proposed an alternative ideology, namely that “getting rich is glorious” (Li, 2004).

Building institutional diversity

Institutional diversity may be as important as biological diversity for a nation's long-term survival. No single property regime for shared resources works efficiently, fairly, and sustainably under all circumstances (Ostrom et al., 1999). History has shown that new institutions evolve from old institutions, and that some old institutions survive the growth of the new ones if they can cooperate or avoid conflict with the new institutions. In fact, retaining effective old institutions can increase social stability and can smooth socioeconomic development during a period of change. Initially, most elements of China's centrally planned economy were preserved with little change while actively encouraging the growth of previously prohibited market-based economic activities, such as family farming, private enterprise, private markets, and foreign-owned joint-venture firms (Whyte, 2009). China’s socioeconomic prosperity since 1979 has resulted from institutional reform in the direction of a market economy while preserving aspects of the old central planning institution to allow the government to correct market failures. Producing goods for the long-deprived domestic market, exporting products to overseas markets, and attracting investment funds from Hong Kong and other sources stimulated local governments to seek new opportunities and establish local factories to take advantage of those opportunities.

As I noted earlier, there are also many historical examples of unsuccessful institutional change, such as China’s Cultural Revolution from 1966 to 1976 (Lin, 2002). To establish a socialist society, Mao attempted to eliminate the remnants of Confucian culture. An estimated 20 million excess deaths occurred and 100 million citizens suffered from poverty and famine (Yang, 2012) because the movement was based on ideology rather than a more rational consideration of the needs of the people. Efforts to achieve pure socialism have failed in many countries that attempted to eliminate aspects of market economies that have been proven to be successful. For example, starting in the 1950s, the Chinese Communist Party confiscated private property throughout China; both private citizens and businesses were forced to give their assets to the state. In 1952, private business still accounted for 55% of China’s industrial output; by 1962, that number had dropped to 0% (Li, 2004). Such ill-considered institutional change can lead to wasted resources, disappointing growth, or even national disasters, as in China’s Great Leap Forward campaign from 1958 to 1960, which led to millions of deaths and a severe economic depression (Whyte, 2009). Therefore, before we try to remedy imperfect or outdated institutions, we should remember that old saying about not throwing the baby out with the bathwater.

Seeking compromise

It is human nature to make decisions based on an ideology rather than incurring the costs to acquire enough information to make an informed decision, even when it would clearly pay to do so. When new institutions are proposed that may result in the redistribution of income or power, leading to substantial losses for some and gains for others, the losers are unlikely to participate unless they will be compensated (North, 1971). To obtain support from the losers, compromise may be required. A good example occurred from 1982 to 1992, when Deng Xiaoping's economic reforms required support from the old leaders who were Mao’s lifelong associates. To reduce the obstacles raised by these individuals, China established an Advisory Committee to let these leaders receive higher payments and share the honor of guiding policy, while simultaneously encouraging them to relinquish some of their power; the Advisory Committee was eliminated in 1992, when most of the members were dead (Zhang, 2007). This is similar in some ways to what happened during the creation of England's Magna Carta (http://en.wikipedia.org/wiki/Magna_Carta) and the changes in the role of Japan's emperor at the end of the 19th century. The goal of a win–win path in this context is to attain a negotiated compromise that balances the needs and interests of each stakeholder. This approach recognizes that optimal solutions may not be achievable, at least in the short term, but that acceptable solutions can be achieved that may lead to better solutions.

Testing institutions by means of demonstration projects

Societies are multilevel systems, with institutions at levels ranging from local to international. These hierarchies lead to differences in the knowledge and understanding of a resource, and these differences are often neglected by those who recommend one-size-fits all solutions, which Berkes (2007) referred to as “blueprint approaches”. Even good intentions will not guarantee good decisions under the pressures imposed by a rapidly changing and complex global economy (Whyte, 2009). Because institutional choice often takes place based on incomplete knowledge, individuals often do not know how to attain the desired results through the existing institutions or how to modify the rules in their favor; they are also not fully aware of which stakeholders may support or oppose them (Goldberg, 1974). Even reforms that will enhance the public welfare may fail if stakeholders cannot predict their gains and losses (Heinemann and Tanz, 2008). In particular, stakeholders may act to protect their institutions when they face perceived threats to their existence (Petr, 1986). On the other hand, if they are given a chance to learn from concrete examples that decrease their fear of change, stakeholders may support efforts to change their institutions.

To minimize the resistance to change, all reforms should begin as experiments to confirm that the reform will work under a region's unique conditions, thereby reducing the cost if a reform fails (Lin, 2002). For example, Chinese reforms have often been a gradual, adaptive process without a clear, thorough blueprint. The development of economic policy has therefore proceeded by trial-and-error, with the central leaders testing alternative solutions to China’s many pressing problems (Lin, 2002). For example, when Deng and his colleagues initiated the 1979 economic and institutional reforms, they chose four towns—Shenzhen, Zhuhai, Xiamen, and Shantou—to test an institutional change towards market economics (Hasan et al., 2009). The small-scale approach minimized the resistance to change by giving stakeholders time to understand the benefits of the new approach, prepare themselves to adapt to the new institution, and learn how to adapt the approach to local needs and constraints (Cao, 2012). One advantage of such small-scale testing is that it lets researchers solve any problems and develop a proven approach before attempting to convince others to adopt the approach. There are two good recent examples of successful use of this approach: in road construction, Chinese researchers have developed new techniques for more environmentally safe construction of mountain highways and near-natural greenways (Xu et al., 2011); and in efforts to control gulley erosion, terraced farm fields were established to provide a livelihood to farmers that would also combat erosion (Zhong et al., 2013). In contrast, monolithic national projects such as the Grain for Green Program and the Three Norths Shelter Forest project were implemented without sufficient concern for differences in local conditions, and have therefore failed in many regions of China (Cao et al., 2011). These examples show that countries cannot succeed by implementing a simplistic one-size-fits-all approach, and must instead tailor their development policies and institutions to the distinctive history, potential, and social and environmental constraints of each region. Demonstration projects provide a means of achieving this goal.

Discussion and recommendations

Institutional change is most often an incremental process, more like “evolution” than “revolution”, and because this approach is gradual, it is less disruptive and allows societies to adapt to socioeconomic, historical, and technological influences (Petr, 1986; Roland, 2004). This form of change is particularly likely to succeed when it follows a win–win path that allows all stakeholders to share in the benefits from the change, while minimizing their sacrifices. Unfortunately, most stakeholders receive relatively minor benefits while a small minority receive most of the initial benefits, and the short-term costs for many stakeholders will not be repaid until economic growth accelerates (Heinemann and Tanz, 2008). Institutional change may therefore fail if the potential losers have more power than the winners to influence the change, and self-interest outweighs the desire of the losers for an equitable outcome. In contrast, a win–win approach can start from the old institutions; for example, a socioeconomic system can be modified to encourage the birth of a new industry and the associated social groups, while the old industries remain in place. Over time, the new industry may grow sufficiently to displace an old industry, as in the case of new private enterprises (Figure 2), or may teach the old industry ways to become more efficient.

The evolution of new social groups that acquire new status, such as the farmers who claimed their own land, employees of private enterprises, and self-employed individuals, is crucial for fundamental institutional change. For example, the Western Industrial Revolution and the associated growth of capitalism during the 18th century generated social forces that accelerated the development of Western democracies (Bowles, 2012). In contrast, democratic institutions and market economies have developed slowly in many developing countries, such as many African nations, due to a lack of new industries and the associated development of new social groups (Mabogunje, 2000). The institutions of a democracy or a market economy can survive and thrive only when economic and other outputs exceed the requirements to support human life. Thus, to promote these institutions, it is necessary to develop new industries and new social groups whose lives depend on the new industries and that are capable of driving the development of these industries. The formal constraints on an industry can change rapidly, as in the case of a government issuing a new law; in contrast, the informal constraints change much more slowly, since these are likely to be social and cultural. Therefore, an understanding of the role of ideology is crucial to promote institutional change, because it is necessary to understand how people think before it becomes possible to apply appropriate techniques of persuasion and compromise. In particular, ways must be found to persuade ideologists to consider opposing viewpoints, thereby avoiding tragedies such as the persecution of Chinese scientists that led to a locking-in of old institutions (Yang, 2012).

In the modern rapidly changing economic environment, a country must be able to undertake institutional reforms to sustain its economic growth and promote the welfare of its citizens (Heinemann and Tanz, 2008). Unfortunately, socioeconomic systems may only adapt in response to the pressure created by clearly inefficient performance. Most approaches to institutional change fail or only partially succeed due to excessive reliance on the philosophy behind the approach rather than attempting to modify the philosophy to account for unique local conditions and due to a failure to consider how difficult it can be to transplant approaches between institutional contexts (Cao, 2012). China’s market reforms promoted rapid economic growth, but also led many government officials to abuse their powers, thereby increasing social inequality, creating environmental crises, risking political instability, increasing the crime and unemployment rates, causing more frequent commercial disputes and protest movements, deepening rural poverty, and spreading infectious diseases (Cao et al., 2014). To promote effective and equitable institutional change, it is necessary to limit the government’s ability to maximize its own benefits, or at least to encourage the government to ensure that others also benefit greatly from the new institution.

Knowledge and cultures evolve slowly, creating large quantities of knowledge that accumulate over time to support innovative solutions and help governments and civilians implement rapid institutional change (Roland, 2004). For institutional change to succeed, policy-makers must understand that different stakeholders require different forms of persuasion. For example, experts may prefer data obtained by research, whereas wealthy stakeholders require reassurance that their wealth will be protected and poor stakeholders require reassurance that they will benefit from the change, even if the wealthy also benefit. Hence, compromise is necessary; it may not be possible to achieve an optimal solution, but it may be possible to achieve a win–win solution in which all stakeholders believe that they will share at least some of the benefits. Furthermore, small-scale demonstration projects must be used to reassure stakeholders that a new approach is both safe and feasible, and that managers in charge of its implementation are willing to be flexible and to adapt the approach to local conditions and needs. These demonstration projects, including the trial-and-error approach that has been used to revise China's economic policy, can weaken or eliminate many of the barriers to change. Because the new institution arises from the old institution, which remains in place during the initial phases, institutional diversity is maintained, and the benefits of the old system are retained until the new system's benefits have been proven.

Footnotes

Acknowledgements

I thank Geoffrey Hart of Montréal, Canada, for his help in writing this paper. I am also grateful for the comments and criticisms of an early version of this manuscript by my colleagues and by the journal's reviewers.

Declaration of Conflicting Interests

The author declares no conﬂict of interest. The opinions expressed here are those of the authors and do not necessarily reflect the position of the government of China or of any other organization.

Funding

The author(s) disclosed receipt of the following financial support for the research, authorship, and/or publication of this article: This work was supported by the National Key Technology R & D Program (No. 2012BAC08B05).

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