3.4.3 Establishing a basis for endogenous change
One of the most powerful changes that can be made to an external institution is to provide a platform for evolution and economic growth. Endogenous change is possible within an open system but it cannot occur in a closed system. Figure 12 illustrates the idea.
Under a tightly regulated system of governance there is little prospect – other than through the imposition of new external institutional arrangements – for innovation to occur. In contrast, under an open system new entities (shown as E in Figure 12) can emerge according to the forces described in Anderson and Hill (1975). The following two examples show how new organisations can evolve in response to a more open system of governance.
The Southern Scallop Enhancement Company (SCEC) is an organisation based on ownership of rights to scallop quota (Sharp, 2002). Obviously, the SCEC was not a feasible organisation prior to the 1986 Fisheries Amendment Act that shepherded in individual transferable quota (ITQ) rights. Thus the 1986 legislation is an “external institution” or “a first order reform” that enabled SCEC to form. Significant innovations were suddenly made possible from this platform – rights in the scallop fishery were further refined. Examples of these “internal institutions” or “second order changes” include rules governing harvest, sanctions for violating company rules, rules for supporting research, and so on. The point to be made here is that parliament-made rules (external) provide a basis for the evolution of other rules (internal).
In 1974 the Wisconsin state legislature recognised the threat to environmental values and public welfare caused by the deterioration of lakes. The legislature acknowledged that the current state effort was not sufficient and noted that the public will benefit from the protection and rehabilitation of these public lakes. Wisconsin Lake Management Law was enacted in 1974, authorising a joint state-local partnership that permits local property owners to organise a lake management district to manage and improve the lake in their community. This evolution of organisational structures is a process of adjusting the rights, the opportunities, and powers of lake property owners relative to the public. Of particular interest is the opportunity for a local community-state relationship to emerge as an effective partnership in lake management. There are approximately 130 Lake Management Districts, over 300 Voluntary Lake Associations and about 30 Town Sanitary Districts.
3.4.4 Path dependency
In the absence of first-order reforms (Sharp, 1996) the evolution of new institutional arrangements will be determined to varying degrees by the institutional structure ex ante. The emergence of quota owner associations provides an example of path dependency. Carey and Sunding (2001) show how the development of water markets is path dependent, varying with the institutional structure emerging from pre-existing property rights and political battles to build consensus and obtain federal money for financing projects. A case study involving two federal government projects – the California Central Valley Project (CVP) and the Colorado-Big Thompson Project (C-BT) illustrates how different market outcomes have emerged from different institutional structures. Most CVP water trades are limited to short-term transactions within the agricultural sector, and are often informal. In contrast C-BT water is transferred in both short and long-term rental markets and permanent sales within and between agricultural and urban sectors. Within the C-BT region there are well-established market prices and water brokers mediate exchange between anonymous users. Four institutional features explain the differences in market activity:
Water district structure: the federal agency negotiates with multiple entities within the CVP whereas it negotiates with only one entity in C-BT.
Water rationing mechanism: a priority system is used to ration water in CVP while a proportional rationing system is used within C-BT.
Acreage limitations: CVP imposes acreage limitations whereas C-BT does not.
Return flow rules: CVP has relatively stricter return flow rules that are designed to protect third parties against adverse effects associated with transfer.
In addition to security of tenure and establishing an initial allocation of rights, the above study highlights the importance of allowing water markets to adapt to long-run changes in water demand. In other words, institutional design should allow for the evolution of new arrangements over time.
