north institutions chap 1

8/13/2019 North Institutions Chap 1

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INSTITUTIONS,INSTITUTIONAL CHANGEAND ECONOMICPERFORMANCED O U G LASSC. NORTH

CnvrnRrDGEUNTVERSITY PRESS


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IAn introduction to institutions andinstitutional change

l"l.dsocial, or economiE. n$ltutional ihange shapeshe way societies volvethrough time and hence is the key to understanding historical change.That institutions affect the performance of economies is hardly contro-versial. That the differential performance of economies over time is funda-mentally influenced by the way institutions evolve is also not controver-sial. Yet neither current economic theory nor cliometric history shows imany signs of appreciating the role of institutions in economic perfor- rr*hSie

Vv: tiAorizing in generaland economics n particular, and provide a new under-standing of historical change.In this study I examine the nature of institutions and the consequencesof institutions for economic (or societal) performance (Part I). I thenoutline a theory of institutional change not only to provide a frameworkfor economic (and other) history but also to explain how the past influ-ences the present and future, the way incremental institutional changeaffects the choice set at a moment of time, and the narure of path depen- ,r,1 \nt ," ,dence (Part II). The primary objective of the study is to achiei6?iiifriFer- i lllendine f the f o6 urp r*


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Institutionsfriends on the street, drive an automobile,buy oranges,borrow money,form a business,bury our dead, or whatever,we know (or can learneasily)how to perform these asks.We would readily observe hat institu-tions differ if we were o trv to makethe same ransactions n a differentcountry * Bangladeshor example. n the istitutions define and,limit the setof of individuals.atshapehuman nteracti6-n-re institutions ormal or informal?They canbe eiiher.and I am interestedboth in formal constraints such as rulestions and codes of behavior. Institutions mUnited Statest am interested in both created and evolving institutions,

for purposes of analysis we may want to examine them sepa-rately. Many other attributesof institutions also will be explored.Institutional constraints nclude both what individuals areprohibitedfrom doing and, sometimes, nder what conditions some ndividuals arepermitted to undertake certain activities. As defiare the framework within which human interacti*-=-*.*?F.-.q.-,-.**F:+*-----.-J:4d to the ru-16 ln a comDetltlve teamcodes of conduct that underlie and supplement formal rules, such as not

r " - ' : - - ' i *deliberatelv iniurine a kev olaver on the 5-Dposine eam. And as thisanalogy would imply,-he rules and informal codeilare-sometimes violatedand punishment is enacted.Therefore, an essentialpart of the functioningof institutions is the costliness of ascertaining violations and the severityof punishment.' Continuing the sports analogy, taken together, the formal and informalrules and the type and effectivenessof enforcement shape the whole char-acter of the game. Some teams are successful as a consequence of (andhave therefore the reputation for) constantly violating rules and therebyintimidating the opposing team. Whether that strategy pays off obviouslydepends on the effectiveness of monitoring and the severity of punish-ment. Sometimes codes of conduct - good sportsmanship - constrainplayers, even though they could get away with successful violations.A crucial distinction in this studv is made between institutions andorganlzatrons. Llke lnstrtutlons, organlzatlons Provlde a structure tofitiinen*ifitiifaction. Indeed when we examine the costs that arise as aconsequenceof the institutional framework we see they are a result notonly of that framework, but also of the organizations that have developedin consequenceof that framework. Conceptually, what must be clearlydifferentiated are the rules from the players. The purpose of the rules is todefine the way the game is played. But the objective of the team within

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An introduction

city council, a regulatory agency),economic bodies (firms, trade unions,family farms, cooperatives), social bodies (churches, clubs, athletic asso-ciations), nd ional bodies schools, niversities, ocational rain-rng centers). of individualsorganlzatlons lshow5-rganization's successover time. Both what organizations codElil-to exrs-tence anilhow they avbl aia fundamentally nfluencedby the institu-tional framework. In turn they nfluencehow the nstitutional frameworkevolves.But asnoted above, he emphas,isn: :s-studfrrcLthg_iryglq-tions that are

lnstltutlons and or.@a l*.i i,,*rintent in consequiiiiEdb-fih,il6pportunityet esulting rom the existingsetof constraints (institutional ones as well as the traditional onesof eco-nomic theory)and in the courseof attempts o accomplish heir objectivesare a major agent of institutional change.Separating he analysisof the underlying rules from the strategyof theplayers s a necessary rerequisite o building a theory of institutions.Defining institutions as the-99rylra-int_sa1 hqgran beings mpose on

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tions that are thtTirdeimnE rulFof theeameand the focuson orqaniza-,---4--:-*T-"< - *..,"+T--l- - - __x,Ftiogg;Qgg[*their entrgrrenegr9)r_ptinqrflf . qn thglg- rgle._+l_gglls*-g."-,-_x-:i*- , .- --r--1"'-*.prlpqrfi ." n thplr-rsle._+9_egqrls*9f. - -r-':**? r -- -'' -;iinstitutional change; hergfore_tLrgmphasiss on the nte-rqctiq{,-._hpjy.g"nnstrtutronal change; Iinstitutions and orsai. , , - - ' - .ge g_?ndorganizations.Organizationsare createdwith purposive

itrmselVE5-niakistlrs dgf.iniiiot cn'Tpl"mente"v o tlii: tho4.e-"- ' -* -*"" . -- ld'ooroach oJ neoclassical economic theorv. Buildine a theorpproach oJ neoclassicaleconomic theory. Building a theory of institu----+iions on the foundafon of individualtE-oices s a step toward reconcilingdifferences etweeneconomicsand the other social sciences. he choicetheoretic approach s essentialbecause logically consistent,potentiallytestable et of hypotheses ust be built on a theoryof humanbehavior.The strength of microeconomic heory is that it is constructedon thebasisof assumptions bout individual human behavior even hough Ishallargue or a changen thoseassumptionsn Chapter3). In_stitutions-?J-e-3,.,99 hurnansameal choicesar6

.. * - _ _ = f " _ % i , flceswltn tne constralnrs nsntunonsa major step toward unifying social science

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Instilutiglsl&Igd, theydeterminehe ransacttoqraldransformationproduction)Zosts haiGi'E6Trtrotel 6G. The ffial objectivef tf,is t,idy (part ) isto explain the existence and nature of institutions to specify the way theyenter into the cost functions in an economv.

ilan.s v{p : The major role of is to reduce uncertainfvistrr-nsl11 T{rtrcqlgu. But the stability of institutions in no way gainsays he factthat theyare changing.Fromconventions, odesof conduct,andnormsof

codesof conduct are-much-trr6iE-irt$EFfi6ffiTs +. -.@++ea*,iF ;E---cultural constrarntsnot only connect the past with the presentand future,but provide us with a key to explaining the path of historical change.The central pluzzleof human history is ro account for the widely diver-gent paths of historical change. How have societies diverged? What ac-counts for their widely disparate performance characteristics? After all,we all descended rom primitive hunting and gathering bands. This diver-gence s even more perplexing in terms of standard neoclassicaland inter-national trade theory which implies that over time economies, as theytraded goods, services,and productive factors, would gradually converge.Although we do observe some convergence among leading industrialnations that trade with eachother, an overwhelming feature of the last tenmillennia is that we have evolved into radically different religious, ethnic,cultural, political, and economic societies, and the gap between rich andpoor nations, between developed and undeveloped nations, is as widetoday as t ever was and perhaps a greatdeal wider than ever before. What

behavior to statute law, and common law, and contracts between indi-viduals, institutions are evolving and, therefore, are continually alteringthe choices available to us. The changes at the margin may be so slow andglacial in character that we have to stand back as historians to perceivethem, although t r. live in a world where the rapidiry of instiiutionalchange is very apparent.Institutional change is a complicated processbecause he changesat themargin can be a consequenceof changes n rules, in informal constraints,and in kinds and effectiveness of enforcement. Moreover. institutiqnsM&r.hausg Isqrrmeue .lx.Jaghg"tlgl'-g-dl'.stlrswl*slashign.owf * - - . - ' - - - . - - .and why theychangencrementallv nd whv evendiscontin'oilchffi;-T--f- -


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An introductionexplainshedivergence?ndperhapsquallymportant,whatconditionseitheread o furtherdivergencesr produce onvergence?There s more to this puzzle.{ atlong-run stagnation or an ute decline nevolutionaryhfp%tfi*ei;lsclnanCe?SiXlEFiann r95o would suggest hatubiquitous competition would weed out inferior institutionsand rewardby survival those that better solve human problems.Let me briefly retrace my steps in dealing with this central issue. InNorth and Thomas (rgZl) we made institutions the determinant of eco-nomic performance and relative price changesthe source of institutionalchange. But we had an essentially efficient explanation; changes in rela-tive prices create incentives to construct more efficient institutions. Thepersistence of inefficient institutions, illustrated by the case of Spain, wasa result of fiscal needs of rulers that led to shortened time horizons and ,1.

pres ffir_{C tot uce economlc . In that study I rathe question ffiTifi-argument, but had no an-swer. t waspossible o explain he existence f inefficient nstitutions,bwhy wouldn't competitivepressuresead to their elimination?Wouldnen fr-ce f economiesover long periodsof time?lcallv differ- *,ed:rI"{"a"This studyanswers hese uestions. he answerhingesg qhedberweeninstitutionsa*4gg3-TgSqlgttalr*d*theiffregllog_kr]yge-gthat shapes"hrsdirectiea gflisstjtu1loggl.,c]*ill,ltlsil"a" rf,?"nitr"ints of .cottoili. i

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An introductionaction costs and the subjective perceptions of the actors resulted inchoices that were certainly not always optimal or unidirectional towardincreased productivity or improved economic welfare (however defined).The profitable opportunities were sometimes from tariff creation, theexploitation of slaves, or the formation of a trust. Sometimes, indeedfrequently, policieshad unintended consequences.n consequencenstitu-tions were - and are - always a mixed bag of those that induce productiv-ity increase and those that reduce productivity. Institutional change, like-wise, almost always creates opportunities for both types of activity. Buton balance nineteenth-century U.S. economic history is a story of eco-nomic growth because the underlying institutional framework per-sistently reinforced incentives for organizations to engage in productiveactivity however admixed with some adverse consequences.Now if I describe an institutional framework with a reverse set ofincentives to those described in the above paragraph, I will approximatethe conditions in many Third World countries today as well as those thathave characterized much of the world's economic history. The oppor-tunities for political and economic entrepreneurs are still a mixed bag,but they overwhelmingly favor activities that promote redistributiverather than productive activity, that create monopolies rather than com-petitive conditions, and that restrict opportunities rather than expandthem. They seldom induce investment in education that increasesproduc-tivity. The organizations that develop in this institutional framework willbecome more efficient - but more efficient at making the society evenmore unproductive and the basic institutional structure even less con-ducive to productive activity. Such a path can persist because he transac-tion costs of the political and economic markets of those economiestogether with the subjective models of the actors do not lead them to moveincrementally toward more efficient outcomes.This study sheds ight on these contrasting stories by providing a the-oretical foundation to the study of institutional change. The next chapterexplores the theoretical foundations of the rinderlying role of institutions- the problem of human cooperation. Then come two key chapters thatprovide the basic building blocks of a theory of institutions. In Chapter 3 Iexplore, critically, the behavioral assumptions we employ and suggestmodifications in those behavioral assumptions, and in Chapter 4 I pro-vide a theoretical foundation to the costliness of exchange and its surpris-ingly important but unappreciated implications.

In the next three chapters I successively describe three dimensions ofinstitutions: formal rules and informal constraints, and the effectivenessof their enforcement. Then I am in the position in Chapter 8 to tietogether the threads and illustrate the relationship between institutionsand transaction and transformation (production) costs.


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InstitutionsPart II provides a framework to analyze nstitutional change. Chapter 9explores organizations and the way they interact with institutions. Chap-ter ro deals with the stability characteristics of institutions, which areessential to understanding the nature of institutional change. The changewe observe is seldom discontinuous (although I shall explore revolution-

ary change) but instead is incremental, and the nature of the incrementalinstitutional change together with the imperfect way by which the actorsinterpret their environment and make choices accounts for path depen-dency and makes history relevant (Chapter rr).Part III relates institutions and the way they change to economic perfor-mance. In Chapter rz I consider the theoretical implications of institu-tional analysis for the performance of economies both at a moment oftime and over time. Chapters 13 and 14 apply the analytical frameworkto economic history. Chapter 13 explores the characteristics of institu-tional change of successively more complex economies in history andcontrasts the stable forms of historical exchange with the dynamic institu-tional change of Western Europe that led to modern economic growth.The final chapter suggeststhe implications of systematically integratinginstitutional analysis into economic history and presentssome extendedhistorical applications.

north institutions chap 1

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