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Institutions, Institutional Change, and Economic Performance

Douglass C. North

Cambridge University Press, 1990; Pages: 152

Review © 2001 Branislav L. Slantchev

Main Thesis

All human interaction is characterized by pervasive uncertainty, which manifests itself in transaction costs to exchange. Institutions are a way to reduce this uncertainty and make it possible to capture gains from trade. Institutions can be informal (norms of behavior, societal codes of conduct) or formal (laws, rules). Both forms involve enforcement, and as society becomes more complex, the need for third-party enforcement arises. This role is played by the state with its coercive powers. A major issue then, becomes the credible commitment by the polity not to abuse its force. Because institutions are designed by people with different bargaining strength and not for sake of efficiency, some patterns may be less efficient than others and due to path dependency, may persist for a long time, resulting in stagnant economy. The lack of credible commitment by the state not to appropriate property rights accounts for the inefficient institutions that have evolved in different countries. To wit, such environment provides disincentives to investment in socially profitable enterprises, and creates groups with vested interests in maintaining the status quo constraints. The key to economic efficiency are efficient property rights, which depend on political efficiency.

Institutions provide the basic structure by which human beings create order and attempt to reduce uncertainty in exchange. Together with technology employed, they determine transaction and transformation costs and hence the profitability and feasibility in engaging in economic activity. The current forms of political, economic, and military organization, and their maximizing directions are derived from the opportunity set provided by the institutional structure that in turn evolved incrementally (p. 118). One gets efficient institutions by a polity which has built-in incentives to create and enforce efficient property rights (p. 140).

Summary of Arguments and Subsidiary Points

Institutions are humanly devised constraints that shape human interactions. They reduce uncertainty by establishing a stable (not necessarily efficient) structure to human exchange, whether political, social, or economic (pp. 3-4). Institutions (together with technology) affect the performance of the economy by their effect on the costs of exchange and production (p. 6). Transaction costs in political and economic markets can result in inefficient property rights, and the interaction between institutions and organizations can produce a lock-in with perverse feedback that accounts for the persistence of inefficiency. Institutions are not usually created to be socially efficient; rather, they (at least the formal rules) are created to serve the interests of those with the bargaining power to devise new rules. If economies realize the gains from trade by creating efficient institutions, it is because the circumstances provided incentives for those with bargaining strength to alter institutions in ways that turn out to be socially efficient (p. 16).

  1. Institutions have three dimensions: formal rules, informal constraints, and enforcement mechanisms.

    1. Informal constraints. They come from socially transmitted information and are part of culture (p. 37). They are not mere extensions of formal rules and will not change immediately in reaction to such rules (p. 45). These constraints arise from the need to structure interaction and reduce uncertainty but we still don't have a good explanation of how it happens.
    2. Formal constraints. Formal rules may increase the effectiveness of informal constraints, modify them, or supersede them (p. 46). Given the initial bargaining strength of the parties, rules facilitate exchange. The extent of diversity of interests will influence the rules' structure (p. 47). In equilibrium, s given structure of property rights and their enforcement will be consistent with a particular set of political rules and their enforcement (p. 48). High transaction costs in the political market often result in property rights that do not induce economic growth and organizations that have no incentive to create more productive economic rules (p. 52).
    3. Enforcement. There are costs associated with imperfect enforcement due to (i) costs of measuring contract compliance, and (ii) enforcement agents having their own utility functions. The inability of societies to develop effective, low-cost enforcement of contracts is the source of economic stagnation (p. 54). The complex contracting that would allow one to capture the gains from trade in a world of impersonal exchange must be accompanied by third-party enforcement (p. 57). However, the state with its control of coercive force, is not a neutral party. Thus, the development of credible commitment on the part of political bodies not to violate contracts, is a necessary condition for economic growth.
  2. Transaction costs arise from the costliness of information needed for measurement and enforcement of the exchange (p. 27). Institutions provide the structure for exchange that (together with technology) determines the cost of transacting and the cost of production. How well institutions solve the problems of coordination and production is determined by the motivation of players, the complexity of the environment, and the ability of players to decipher and order the environment (measurement and enforcement) The three general types of exchange are personal, impersonal, and impersonal with third-party enforcement (pp. 34-5). Institutions determine transaction (defining property rights, enforcing contracts) and transformation (type of technology employed, efficiency of factor and product markets) costs. Because markets are imperfect, institutions are a mixed bag of rules that lower costs and those that raise them (p. 63).
  3. Organizations are purposeful entities designed by their creators to maximize their objectives defined by the opportunities afforded by the institutional structure (p. 73). The institutional context determines the incentives for the kinds of knowledge and skills that pay off; this knowledge has implications for the long-run development of society (p. 78). Organizations will (a) change institutions at the margins whenever this is more profitable than investing in existing constraints; and (b) encourage society to invest in skills and knowledge that contribute to profitability (p. 79). Adaptive efficiency provides the incentives to encourage the development of decentralized decision-making processes that will allow societies to maximize efforts required to explore alternative ways of solving problems (p. 81).
  4. The process of change is overwhelmingly incremental (through continuous marginal adjustment) and the sources of change are changing relative prices or preferences (p. 83). Changes in relative prices, such as changes in the ration of factor prices, or changes in the cost of information and technology, can be exogenous (e.g. due to plague) but are mostly endogenous, reflecting the maximizing efforts of entrepreneurs (p. 84). Why do inefficient institutions persist? From literature on evolution of technology we know that it is possible to adopt a technology, which turns out to be less efficient than the available alternatives. This is due to (i) multiple equilibria-a number of possible solutions, indeterminate outcome; (ii) possible inefficiencies-a better technology loses out due to bad luck in gaining adherence; (iii) lock-in-once reached, a solution is difficult to exit from; and (iv) path dependence-the consequence of small events and chance can determine solutions that lead to a particular path (p. 94). There are two forces that shape the path of institutional change: (i) increasing returns; and (ii) imperfect markets with significant transaction costs (p. 95). Path dependence narrows the choice set and links decision making through time. Unproductive paths can persist because the initial set of institutions can provide disincentives to productive activity and create interests with a stake in existing constraints (p. 99).

Historiographical Observations

A theoretical work, divided into three parts. The first part deals with institutions: definition, importance, formal versus informal, and enforcement. North defines the basic problem as that of cooperation which allows people to capture the gains from trade and then explores how institutions emerge to reduce the fundamental uncertainty of exchange. He shows how informal and formal constraints shape human interaction and how enforcement mechanisms are necessary for both. Part II deals with institutional change; in particular, North shows how organizations are created to take advantage of opportunities provided by the existing institutional environment and how certain institutions can provide incentives to entrepreneurs to invest in socially profitable enterprises and/or attempt institutional change at the margins. North concludes that all institutions have developed over time, are thus path-dependent, and provide a clue to understanding the different evolutionary paths of societies. Finally, part III deals with the effect of institutions on economic performance, with the basic claim being that efficient property rights are necessary for growth.

June 30, 2001. BLS 

@BOOK{north-90:institutions,
    TITLE     = {Institutions, Institutional Change, and Economic Performance},
    AUTHOR    = {Douglass C. North},
    YEAR      = {1990},
    PUBLISHER = {Cambridge University Press},
    ADDRESS   = {Cambridge},
    ISBN      = {0-521-39734-0},
    NOTE      = {Pp. 152}
}