The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002
Douglass C. North & Robert Paul
Thomas
An Economic Theory of the Growth of the Western World 1
The Economic History Review
New Series, Volume 23, Issue 1
Apr. 1970, 1-17.
Index
(HHC: titles added to numbered sections)
THE object of this article is to present a new
explanation for the economic rise of the Western world. While the model presented below has
equally radical implications for the study of contemporary economic growth, our
focus is upon the economic history of the nations that comprise the
In subsequent sections of this article we shall (i)
summarize (mostly from price history and population studies) the general
contours of economic changes in Western Europe from 1100 to 1800, (2)
provide an economic explanation for these changes, (3) develop a theoretical
approach to institutional change, (4) integrate the analysis of economic change
with the model of institutional change, and (5) explore briefly the
implications of this general model.
There exists only fragmentary information on the
economic contours of society between 1100 and 1800. We know that sustained economic growth
emerged some time before the latter date and has continued ever since, although
we are unaware of just when it began. We also know that the world prior to,
say, 1500 - if not
1. This essay is a drastic condensation of a forthcoming
book by the authors and of necessity has eliminated extensive bibliographical
references. We are indebted to
Stanley Engerman and to our colleagues Mary Eysenbach, John Floyd, and M. D.
Morris for helpful comments on an earlier draft.
1
typical of what we would call a stationary state - still
shows no evidence of having achieved continuously rising per capita
income.
What follows is a brief summary of our knowledge -
fragmentary, incomplete, and occasionally contradictory (particularly with
respect to the demographic evidence). We should caution, to begin with, that
regional variations marked Western Europe, so that the general contours of
population change and price movements described above were not always parallel.
Nevertheless, general patterns do
emerge; and these appear to offer hard enough evidence to justify an attempt to
construct a more general theoretical model with which to interpret this
information.
Scholars generally agree that in the twelfth century
Neither demographic data nor relative price data enable
us to say exactly when population began again to expand. Since large amounts of good land were
available to be put into production, population could grow for some time before
relative price changes reflecting diminishing returns in agriculture would
signal the onset of population pressure. Some time during the fifteenth century,
therefore, a turning-point was reached, although the abundance of available
land, and probably some increases in productivity, may for a time have
maintained rising per capita real income in the face of a growing
population; the evidence on this is not conclusive. The classic work of
It would also appear that this was an era of population
expansion accompanied by significantly diminishing returns in agriculture. John U. Nef has suggested that
technological change in the latter part of this century brought about some
advance in productivity. It is
doubtful whether this was of a magnitude to over-
2
come diminishing returns in agriculture. The more likely inference is that
increased productivity served merely to damp the Maithusian checks, allowing a
larger total population to exist before the inevitable population pressures
resulted, in the seventeenth century, in another crisis with population
outstripping the rate of growth in output. If population did not absolutely decline
in Western Europe during this century, it appears at best to have
stagnated.
During this period there is clear indication that
productivity change occurred in a number of sectors, the most apparent being
substantial improvements of productivity in transportation. Not only was the Canal du Midi
constructed in the seventeenth century; more impressively, unequivocal evidence
points to an improvement of efficiency in ocean transportation leading to
falling real costs in the movement of goods. The extensive grant of patent monopolies
in
Another turning-point appears to have come somewhere in
the latter part of the seventeenth century - perhaps 168o is as good a date as any. Again, from 168o to the mid-eighteenth century
substantial population growth occurred on the Continent. Prices remained relatively stable, and
there appears to have been some rising per capita real income during the
period. By now, one sees
indisputable evidence of widespread improvement in productivity, not only in the
form of continuing gains in transportation (particularly in shipping) but also
as a result of widespread changes in the character of agriculture. These have been highlighted in many
regional studies in agriculture, pointing, in the cases of
An explanation of this demographic, price, and
productivity behaviour can be summarized as follows. Before the middle of the twelfth century
growth in population led to new colonization and settlement, and output grew as
rapidly and probably more rapidly than population, so that per capita
income increased. The urge to
colonize and settle new areas would develop when relative overpopulation and
diminishing returns in an existing settlement led to a falling off in
well-being. This process could be
slowed down by farming the given settlement more intensively, but as population
continued to grow it would ultimately induce people to move out into new
“frontier” lands. The spread of
population through
3
facturing - in particular of wool cloth - developed in
the more densely settled areas and the cloth trade grew. Thus, interregional trade was a natural
consequence of the differential factor endowments concomitant with the spread of
settlement in
However, as
The inception of this sustained increase in productivity
can be accounted for only by a theory of institutional change, and this is to be
developed in the following section of this essay; but the pattern of population
change, relative price movements, and the growth of interregional trade can be
explained in terms of a strictly economic model which we shall call a Malthusian
staple-thesis model. While this
model oversimplifies the evolution of
4
Economic institutions, and specifically property rights,
are generally considered by economists as parameters; but for the study of
long-term economic growth they are clearly variables, historically subject to
fundamental change. The nature of
existing economic institutions channels the behaviour of individuals within the
system and, in the process, determines whether the aggregate result is to be
economic growth, stagnation, or decay.
Before we proceed farther, a definition is needed. Common usage of the term “institution”
defies precise meaning since it has variously referred to an organization (such
as a bank), to the legal rules that govern the economic relations between people
(private property), to a person or position (king or monarch), and sometimes to
a particular document (the Magna Charta). For our purposes, we shall define an
“institution” or an institutional arrangement (which is a more accurately
descriptive term) as an arrangement between economic units that defines and
specifies the ways by which these units can co-operate or
compete.
As in the more familiar case of the introduction of a
new product or process, economic institutions are innovated because it appears
profitable for individuals or groups in society to undertake the costs of
bringing about such changes. The
purpose is to capture for the innovator some profit unattainable under
the old arrangements. The
essential requirement for initiating an institution (or a product) is that the
discounted expected gains exceed the expected costs of the undertaking; only
when this condition is met would we expect to find attempts being made to alter
the existing structure of institutions and property rights within a society.
We shall explore successively the
nature of potential gains and potential costs in such innovation, and then
discuss the economic forces that would alter the ratio of these costs and gains
through time.
Potential profit from a number of general sources can be
captured by institutional innovation, whether of a voluntary sort or undertaken
by use of the coercive powers of government. To accomplish voluntary organizational
change, a group of individuals may choose to place themselves under a common set
of rules governing their behaviour. Since each member retains the right to
withdraw, the organization will exist only so long as it serves the interests of
the group. Partnerships,
corporations, and co-operatives are examples of such organization. Differing fundamentally are organizations
under government aegis, since in this case the force or coercion of government
may be exerted to require specific performance and the individual may no longer
withdraw from membership and the coercive consequences of the
policies.
Potential benefits that historically have induced
institutional innovations and thereby actually raised the productivity of
society result from (i) economies of scale, and (2) reduction of transactions
costs, which can best be viewed as the costs of operating an economic system.
The latter in turn can be separated
into
1. The intellectual origins of the theory set out in this
section can be traced to W. F. Baumol, Welfare Economics and the Theory of
the State (Cambridge, Mass., 1952); Anthony Downs, An
Economic Theory of Democracy (New York, 5957); J. Buchanan and G. Tullock,
The Calculus of Consent (Ann Arbor, Michigan, 1962); Harold Demsetz, ‘Towards
a Theory of Property Rights’, American Economic Review (Proceedings, May
5967); Kenneth Arrow, ‘Political and Economic Evaluation of Social Effects and
Externalities’, Universities National Bureau Conference on the Economics of
Public Output (unpublished, cited by permission of the
author).
5
the costs of externalities, of information, and of risk.
Both the realization of economies
of scale and the reduction of transactions costs have been significant sources
of profit to groups undertaking institutional
rearrangement.
Economies of scale are essentially a technological
phenomenon and reflect the fact that the most efficient (lowest cost per unit)
output may entail a size that requires more complex organization than the single
proprietor. The growth of chartered
companies, joint-stock companies, the corporation, and the legal provision of
limited liability provide classic examples of how institutions and property
rights were created to permit individuals to capture the profits inherent in
economies of scale. Such
organizations were first sanctioned by government, then later became voluntary,
within a set of property rights designed to allow businesses to organize on a
large scale.
Among the transactions costs mentioned above,
externalities have received the most attention. By an externality we mean that some of
the benefits (or costs) in a transaction accrue to other than the directly
participating parties. In modern
times we think of the downstream benefits of a dam, or, historically, of pirates
and privateers preying upon commerce, as familiar examples. An even more significant historical
example is the inability of an entrepreneur to capture the gains from an
innovation without the legal protection of intellectual property. In each case, the profits to the
potential dam-builder, trading merchant, or innovating entrepreneur are lower
than they could be by appropriate institutional rearrangement. A change in tax structure or property
ownership could permit the dam-builder to capture downstream benefits. A naval force could wipe out pirates,
thereby seeing that merchants rather than pirates reaped the gains from trade,
and an enforceable patent law would see that an innovator captured the gains
from his innovation. The
internalization of an externality by reorganizing prperty rights,
institutional innovation, or the policing of markets not only will raise the
private profitability of the activity but, as in the case of economies of scale,
will also improve the efficiency and output of the society by equating the
private and social profitability of an activity.
A less explored aspect of transactions costs is that of
organizing and improving the flow of relevant economic information, yet this has
historically been a major area of institutional
innovation.
If there were no costs to acquiring information then
prices in all markets would differ only by transport costs. In fact, information is costly and the
widespread existence of purely local markets reflected in good part simply the
lack of information about profitable trading opportunities in more distant
areas. The development of such
information meant that merchants would send their products to the markets where
net price differentials (i.e. prices adjusted for transport costs) were highest;
thus the development of institutions to increase the flow of information
increased the merchants’ profits. The development of the whole network of
trading institutions - merchants, brokers, factors, supercargoes, early
exchanges in coffee houses, stock and commodity exchanges - were all directed
basically to this end. Eventually,
it became profitable to produce and sell this information in such forms as price
currents or trade association journals. Like the two previous sources of
institutional innovation, these were not only privately profitable to the
merchant and entrepreneur but by arbitraging markets were
a
6
major source of productivity increase and economic
growth in the Western world.
The prevalence of risk - the inability to be certain of
the terms on which future transactions can be made - is yet another cost
limiting the extent of transactions. The possibility of very high losses on an
individual transaction will inhibit such enterprises even though when averaged
out over a sufficient number of undertakings the average rate of return may be
very high indeed. The creation of
institutions to spread risks would clearly make it possible for entrepreneurs to
realize these higher rates of return without the risk of disastrous consequences
when an individual venture failed. The early share-partnership in shipping
and trade, the joint-stock company, and insurance associations (such as Lloyd’s
of London) were created precisely to capture the profits from such high-risk
ventures. Since the high potential
profits mirrored the social rate of return, the development of such institutions
to spread risk also led to productivity increase. We should note in passing that many
institutional innovations were created both to increase information and to
spread risks (many types of financial institutions, futures markets,
etc.).
The above types of innovation are associated with
institutional change which also improves the efficiency of the economy. Yet, quite clearly, this is not the only
kind of individually profitable institutional innovation that may occur. Institutional arrangements may also be
created, either by voluntary groups or by the government, which are designed to
capture gains for individual groups at the expense of others (or, in short, to
redistribute income). 1 We may conceive of any group which is organized to
control supply effectively as being able to redistribute income in its favour.
The guild system may provide one
example; or we can note various attempts through coercive power of government to
undertake such activities: typical are the several attempts to fix wages
following the era of the Black Death or, to take a different example, the Poll
Tax of 1381 in
Institutional arrangements are not costless to create.
The cost of forming both voluntary
and governmental associations varies directly with the numbers involved; the
greater the number that must be brought into agreement, the greater are the
costs incurred.
2 Since voluntary organization presumably also implies the
privilege of voluntary withdrawal, such organization must in effect exist under
a unanimity rule. 3
However, in considering organization by government one
must look carefully at the potential costs. Until a more sophisticated theory of the
state is developed by political scientists, we can only specify at discrete
points in time the structure of political power and decision-making rather than
provide a dynamic theory of political change. In a democracy the costs of effecting a
particular policy will typically be those of obtaining the support of 5I per cent of the populace
under majority rule. But when we go
back in time to explore the issues that concern us in this essay, decision rules
with respect to political change are more difficult to as-
1. Institutional innovations designed to realize the gains
inherent in economies of scale or to reduce transactions costs will probably
also redistribute income within the economy, but this effect is a byproduct of
the primary objective. On the other
hand, institutional innovations designed primarily to redistribute income will
generally not raise society’s output and will usually lower
it.
2. This very brief discussion of the costs of organization
is amplified in Buchanan and Tullock, op. cit. ch. 8.
3. This means that the participant must view the cost of
withdrawal as exceeding the cost of the policy with which he
disagrees.
7
certain. This is not to deny that changes could be
effected in political policy at some particular cost. The most obvious method that comes to
mind is the bribing of kings and princes who were notoriously hungry for funds
to run their governments. Historically, we observe many
innovational changes accomplished by the use of discreet bribery, sometimes in
the guise of loans. But for these
earlier forms of political change we do not yet possess even the embryo of a
general theory such as we are beginning to achieve for changes occurring under a
political democracy. 1 Therefore, so far we must conclude that decision rules
must have varied widely over time, and we are unable at this point to specify
them accurately. We must simply
assume the ability of groups in society through time to modify decision rules or
to modify the political process.
We should note an additional cost incurred in the
political process but absent in the voluntary system: once agreement has been
reached to pass a law, all citizens become subject to that law whether they
approve of it or not. These are the
costs of coercive agreement. For
example, when the peasants of feudal
What will decide whether groups choose voluntary rather
than governmental means of implementing institutional innovation? The answer must be the relative benefits
and costs of the alternative methods, and our brief outline above suggests some
of the benefits and costs that might exist. We may note that the social costs appear
to be greater in general for governmental organization; but we should also
realize that in many instances the benefits will be still greater. The most obvious reason for this is the
coercive power which permits government to undertake policies even though they
may be strongly objected to by a part of the society. Coercive power is exerted through the
capacity to collect taxes, to enact regulatory legislation, and to institute
eminent domain proceedings. The
relative benefits and costs will be particularly influenced by the degree of
development of government “infrastructure” as compared to the degree of
development of the market. The era
of “mercantilism” represents a period when the government structure was
relatively well developed and the markets were small, fragmented, and often
monopolized. Merchants and
entrepreneurs turned to government to open up markets, to break down local
monopolies, and to provide naval and military protection for trade; in short, to
undertake the institutional innovations essential to internalizing externalities
and reducing transactions costs.
So far our exploration of the basis for institutional
innovation has not explained why such innovation tends to occur. But we must remember that presumably
ex-
1. Even for political democracies the theory is tentative
and a long way from satisfactory; Buchanan and Tullock, op. cit. and
8
ternalities or transactions costs exist at any given
moment because no group in society judges it profitable to internalize the
externality or to arbitrage out the market imperfections associated with other
forms of transactions costs.
Equilibrium among economic institutions exists when the costs of change
(to the individual or group) exceed potential benefits. Therefore, to induce institutional
innovation, some disequilibrium must occur in the system that adds weight to the
profit side in the judgement of the decision-making individuals or groups, i.e.
the perceived benefits must have risen, the costs fallen, or
both.
Several factors appear to have created disequilibrium in
the social structure of the Western world. The ones that we will subsequently focus
on in this essay are: (i) long-run changes in relative product and factor
prices, (2) changes in the size of the market, and (3) changes in the decision
rules of government.
1
Long-run changes in relative factor and product prices
have led to fundamental institutional changes. For instance, changes in the relative
value of land and labour altered the profitability of “owning” one versus the
other and destroyed the basic raison d’étre of feudalism. Rising agricultural prices increased the
value of land and made it profitable to develop exclusive ownership of land
(i.e. develop private property in land). With growing population and a relatively
fixed supply of land, labour services became decreasingly valuable, thus
providing the basis for the development of a free labour force. When relative prices reversed, the
pressures for institutional change worked in the opposite direction. Changes in relative prices also led to an
expanded basis for interregional trade and caused other changes, to be
elaborated in Section IV below (pp. 10-16).
The increasing size of the market has historically
weighed heavily as a force for institutional innovation. Transactions costs tend to be subject to
economies of scale. The cost of
getting additional information about prices maybe independent of the size of the
market involved, and a larger potential market makes it worth while to acquire
information which would have been unprofitable in a very small market. This would appear to be true with respect
both to improving information and to reducing externalities in such cases as the
policing of piracy or brigandage.
For example, the cost of establishing a resident factor
in a foreign port is approximately the same whether trade with that area is of a
value of ₤1,000 or 1 million annually. The reduction in costs through better
information on prices and quantities may not be worth while in the first case,
but is more likely to be so in the second. Similarly, when trade with the
Changes in decision rules of the government are a factor
which can be referred
1. While changes in factor prices resulting from population
growth and changes in decision rules of government are exogenous, changes in
market size are partly endogenous (from population growth and relative price
changes) and partly exogenous (from political and military actions). Other forces which produced
disequilibrium were changes in the norms of behaviour - such as the willingness
of the populace to accept private property - and innovations. The acceleration of innovation is
endogenous to our model, but some innovation would and did occur even in the
absence of institutions which enabled the innovator to capture a large share of
the benefits of the innovation. They were generally confined to chance
discoveries or innovation that involved few search costs or risks. The pace of such innovative activity was
so slow that the consequent productivity increase was subsequently swamped by
population growth. The introduction
of the three-field system is a typical case in point.
9
to only briefly - at least in this essay. But, clearly, these must play a large
part in any overall examination of the evolution of the Western world. The relative power of the crown, of
feudal lords, and of the towns - and changes in their relative power over time -
were in fact changes in decision rules which basically altered the costs of
calling on government to implement economic policy. At present, we simply lack any body of
theory to explain these changes.
It should now be evident that we are talking about two
different levels of institutions. There are the fundamental institutions
that specify the basic “ground rules” such as the underlying “constitutional”
basis of property rights and basic decision rules with respect to political
decision-making, and then there are the secondary institutional arrangements
which may be created without altering the basic institutions. The fundamental institutions may be
specified in a constitution or may exist by legal precedent or perhaps only by
custom. Sometimes the ways in which
these fundamental institutions can be changed are specified, as in the rules for
amendment of a formal constitution, but more often they are not. The innovation of secondary institutional
arrangements may sometimes take place without any political or legal change, but
others require political implementation. Historically, many secondary
institutional developments have been entirely consistent with existing basic
institutions; but the implications of others have been in conflict with the
status quo of property rights or of political decision rules. As such secondary innovations take place,
political pressures accumulate to induce a reorganization of the fundamental
institutions.
As already emphasized, institutional innovation does not
necessarily lead to growth. Some
institutional changes lead to the redistribution of income and actually reduce
output. The history of ancient
civilizations as well as of most underdeveloped economies today bears witness
that it has often been more profitable for entrepreneurs to develop institutions
to redistribute income than to innovate productivity-raising institutions. The essential key to our essay is that
cumulative changes in secondary institutional arrangements ultimately led to a
restructuring of fundamental institutions in Western Europe over this period, in
such a way that individuals in the society were now encouraged to strive for
greater productivity in their economic undertakings. New incentives had arisen in the form of
increased private profitability of innovation and improvement in the quality of
factors of production. To put it
more specifically, while the social rate of return on innovation and capital
formation (both human and physical) had always been high, changes in
organization and property rights increasingly brought the private rate of return
accruing to individuals and groups nearer the social rate of return. Growing efficiency was the inevitable
result.
The implications of the preceding sections are that
basic economic changes have created a potential for profitable opportunities
which could be realized by the innovation of economic institutions. In this section, we shall explore these
implications in what must, of necessity, be no more than a brief sketch. Our primary objective is to illustrate
the promise of this model. The
illustrations will mainly be drawn from English
experience.
10
While our model has implications for the way in which
feudal institutions evolved, we here examine only the way in which they declined
and were replaced. The basic
economic characteristics of the medieval world before 1100 were these: (1)
abundant land was available for colonization and settlement, of approximately
equal quality to that already settled; (2) labour was relatively the scarce
factor of production; (3)
of the small volume of trade, most was confined to local exchange of
goods and services: what long-distance trade existed was based essentially on
differentials of resource endowments between regions, occasionally including
differentials in specialized human capital investments; (4) the rate of
innovative activity appears to have been very low.
The force which upset this economy was population
change. The fundamental
institutions of feudalism had developed because of the scarcity of labour
relative to land, which made it imperative to capture from labour the rents not
existing from a ubiquitous supply of land. 1 Population pressure undermined the economic basis for
the institutional organization of feudalism by reversing the relationship of
prices as a result of diminishing returns and by expanding the size of markets.
Increases in population relative to
a fixed supply of good land led to agricultural prices rising relative to
non-agricultural prices; this in turn increased the value of land and decreased
real wages as the output per labourer fell. Growing population, colonization, and
consequent different regional factor endowments led to expanding trade. The result was that landlords now found
it to their interest to commute labour dues to payments in kind and in cash, and
to lease the demesne lands in return for rent.
On the other side of the scale the rising value of land
also produced a basic disequilibrium in the medieval world. Land now offered vastly higher returns if
only they could be captured by individuals: a continuous pressure arose to
eliminate common-property use of land and to achieve private exclusive
ownership. The enclosure movement,
undoubtedly the most dramatic of the institutional changes induced by this
relative price change, resulted in a reorganization of property to permit
exclusive ownership. Voluntary
enclosures date from precisely this period.
Population pressure also exerted significant effect on
the non-agricultural sectors of the economy. Because it was unevenly felt throughout
Western Europe, and not felt at all in Eastern Europe, the result was to
differentiate increasingly the relative factor endowments of different regions
and this, in turn, led to greater reason for trade. However, potential profits from trade
were obstructed by high transactions costs due to lack of information about
potential markets and to the existence of piracy and brigandage on a widespread
scale. Not surprisingly, merchant
groups now undertook concerted action to reduce these costs. The development of merchant-trading
groups, the establishment of resident factors in different cities to increase
information flows, and a drive to eliminate or reduce piracy on major trade
routes during this period were all designed to enable merchants to capture the
ever-growing gains inherent in long-distance trade. Deposit banking,
1. Prof. Evsey Domar, in an unpublished essay which he has
been kind enough to show us, constructs a model which explains the perpetuation
of serfdom in Eastern Europe (in contrast to its demise in Western Europe) in
terms of a gentry having the ability to appropriate “rents” from labour when
land is ubiquitous. In contrast, in
11
insurance, and predecessors of the corporation were just
three examples of institutional arrangements developed to reduce information
costs and risks during the period.
The expansion of trade led to two other significant
institutional consequences. (1) Formal contracts came to
replace the earlier informal agreements, as the size of the market made trade
relationships more impersonal; the rise of contractual obligation was an
important step in the development of property rights. (2) Existing political administrative
units were increasingly inadequate to meet the needs of expanding trade which
required a wider scope of fiscal policies, policing protection, and information;
consequently, larger political units grew up or consolidated to keep pace with
the growing market size.
As discussed in the preceding sections, we do not know
exactly when a check in population growth tended to counter these processes.
However, the effects of the long
decline in population were striking. Relative prices reversed. Land now relatively more abundant became
less valuable; labour became more scarce and, as a consequence of competition
between lords to acquire labour, more dear. To recapture the loss in rents from the
now more valuable labour, the lords attempted to use their political power to
reimpose feudal obligations. Peasants and labourers, on the other
hand, saw freedom from these obligations as a chance to capture more fully the
returns of their own labour, which had now risen strikingly in terms of real
wages.
Our model, in these circumstances, would predict a
period of rising social tension and of conflict between these groups, requiring
an exploration of the structure and distribution of political power of the times
to foresee its resolution. To the
extent that the political power resided with the lord, he would be able to
re-impose feudal obligations; to the extent that it was more widely diffused
among diverse political interests, he might be less able to capture again the
rents from labour.
With respect to the non-agricultural sector of the
economy, the decline in population served to reduce the aggregate volume of
trade in two ways: it affected both the total size of the market and the
difference between regions in
1. The
12 Index
activity) even in the midst of this world where higher
per capita income would presumably have followed the relatively increased
real wage that peasant and worker must have been
experiencing.
With the advent of the sixteenth century the changing
pattern of relative prices leaves little doubt that diminishing returns had
obviously once again set in. Real
wages declined dramatically throughout the century. While the decline in real wages and in
the value of labour tolled the final and ultimate demise of feudal obligations
(since labour became relatively less valuable), it equally rang in the effective
rise and fundamental institutionalization of private-property ownership as a
consequence of rising land values. The enclosures taking place at this time
occurred in areas precisely predicted by the theory we have sketched - in
pastures producing raw wool and in areas suitable for truck farms. The former was in response to an
expanding demand for raw wool and the second to increases in local demands for
foodstuffs by the growing urban areas. The sixteenth-century enclosure movement
was most extensive in the highland regions of
The arable land areas of southern
Turning again to the non-agricultural Sector, we find
two basic forces making for a rearrangement of institutions in these centuries.
The first, which had already
existed in the earlier period, was the divergence in relative prices due to
differen-
13
tiation of factor endowment among different regions in
A classic example of an institution evolved under the
impetus of such newly profitable opportunities is the joint-stock company. This arrangement not only served to
spread risk by making shares available to individual owners but it also
increased information about trade by stationing resident partners in various
locations and at times even protected its participants by its own police
power.
The international financial markets which grew up in
The expansion in the size of the market encouraged
innovation in two basic respects: the first was a natural consequence of
specialization and the division of labour in the classic sense that Adam Smith
described the process. In terms of
our model this simply lowered the costs of discovering an innovation. The second was that the expansion in the
size of the market raised the potential returns to innovation. However, as long as the innovation was
freely available to be adopted by other entrepreneurs, most of the benefits
generated could not be captured by the innovator.
The granting of monopoly privilege by the Elizabethan
crown to ensure that
14
inventions introduced in
The implications of the Statute of Monopolies far
outreached the statute itself. In
an earlier period, the power of government had been the most feasible agent to
break down such barriers to trade as the threat of piracy and the proliferation
of local monopolies; the very basis of mercantilism had been a tacit banding
together of government and merchants to realize profits from commercial
venturing. By the end of the
sixteenth century, markets had widened and the potential gains from expanded
foreign and domestic trade had increased to the point where government
intervention not only seemed unnecessary but was now actually costly and hence
unwarranted. Officially created
monopolies now thwarted merchants and traders bent on capturing the growing
trade. Even when the granting of
monopolies was first inaugurated some grants had been tossed as largesse to
court favourites (and were therefore purely redistributive in effect rather than
a stimulation to trade). Now all
monopolistic grants became increasingly suspect as vehicles of privilege and as
devices to redistribute income by denying free access to the profits inherent in
expanding markets. Pressures arose
to oust the government and its monopolistic grantee groups from their entrenched
positions.
The fundamental political conflicts of the seventeenth
century reflect this resistance to oppressive influences in trade and commerce;
the evolution of the first voluntary business organization, in the form of the
joint-stock company, was a logical development. In this context, the crises of the
seventeenth century and the revolutionary period between 1640 and 1688 are fully
consistent with the model we have outlined.
It is clear that by this time substantial productivity
increase was already taking place in the Western world. We see it strikingly evidenced in the
case of shipping, where the gains stemmed not from technological change but from
the decline of piracy (allowing a decline in crew size) and from the growing
size of markets which reduced turn-around time and port time for ships. All these phenomena manifested declining
transactions costs of the kind we have described. 2 A productivity change similar to that described for
shipping was also happening elsewhere, particularly in trade and commerce, where
transactions costs were moving inversely to the growing volume of trade and
commerce.
Sustained economic growth in the Western world required
the creation of institutions and property rights that served to bring the
private rate of return to individual activities more nearly in line with the
social rate of return. This means
that the individual’s perception of his own gains from undertaking an
activity
1. ‘Innovation and Diffusion of Technology: A Theoretical
Framework’, by Douglass C. North, is forthcoming in the Proceedings of the
Fourth International Congress of Economic Historians at Bloomington, Indiana,
and is to be published by the University of Indiana Press.
2. See Douglass C. North, ‘Sources of Productivity Change in
Ocean Shipping, 1600-1850’, Journal of Political Economy, LXXVI (1968).
15
would in practice closely approximate to the benefits
that society would receive from that activity. This necessitates a set of property
rights and institutions that ensures that the factors of production directly
receive their economic value.
Because it lacked such provisions, the late medieval
world was beset by population growing more rapidly than output. Much of the land was held in common (and
all had ill-defined property rights); when it became scarce, no economic
incentive assured its efficient utilization. Labour, tied by law and by custom to a
specific activity, had neither the opportunity nor the incentive to increase its
productivity, either by seeking its most efficient employment or by improving
its efficiency in its existing occupation. The institutions and legal attitudes of
feudal
In contrast, the English economy at the end of the
seventeenth century had achieved or was in the process of creating within its
social structure a set of institutions and a common law that jointly encouraged
improvements in productivity. Each
factor of production was able to receive the bulk of its economic value. Land was in the process of passing into
private hands, with the owner having the right to exclude others from its use
and freely to alienate his property. Any improvements made were captured by
the owners, who therefore were motivated to use their property to obtain the
highest returns. Labour had been
freed (with minor restrictions) to seek its best employment; what skills a
workman developed were his to sell as best he could, as he was no longer subject
to arbitrary exploitation by some third person. The development of private property and
the legal enforcement of contracts reduced the externalities and risks that had
been present in the feudal world, thereby raising the rate of return on undertaking all kinds of
economic activities. The
development of a patent system and other laws protecting intellectual property
(however imperfectly enforced) encouraged the growth of innovation. In addition to the patent system (which
was always imperfectly enforced) prices, bounties, and subsidies were all used
to encourage innovation and produced the same consequences in terms of our
model.
In effect, a cumulative series of once and for all
secondary institutional arrangements had gradually led to the reorganization of
the fundamental institutional structure. This basic change was clearly evidenced
by the characteristics of the property rights that had evolved. The social milieu of
The explanatory sketch outlined above suggests that the
cause of the rise of the Western world was the redirection of incentives as a
consequence of the development of institutions which made it more profitable to
attempt to increase productivity within any economic activity. Such institutional innovations, as we
-have pointed out, are in direct contrast to those that throughout most of the
history of mankind have served mainly to redistribute income. The two major
16
forces making for this change in the Western world were
variations in relative prices and expansion in the size of the market.
1
Because the theory rests on response not only to market
forces but also to non-market forces inherent in the coercive power of
government, we cannot make any definitive statement about the inevitability of
such an outcome; presumably some combination of political power under other
circumstances could have thwarted the pressures for productive institutional
changes - as they clearly have done in other societies up to the present
day.
This point requires emphasis. There is no way to predict the outcome of
conflicting political groups or coalitions, and therefore there is no certainty
that political policies which will induce “productive” economic changes will be
passed. We do not have a theory of
the state that allows us to predict the outcome of such political conflicts, and
indeed the theory of non-zero sum games suggests in fact that the results are
indeterminate.
Nevertheless, in spite of these limitations on the
explanatory sketch developed above, the implications and promise are
revolutionary enough.
1. There are striking similarities - and differences -
between this model and a Marxian model. In both, the development of a system of
private-property rights was a critical aspect in unleashing the productive
forces of economic growth (capitalism in the Marxian terminology). There are other similarities in the
analysis of the characteristics of the feudal economy and the capturing of rents
(surplus value) from the labour of the serf. Both this model and Marxian writing on
the seventeenth century look upon it as a century of turmoil in which a basic
restructuring of political power was necessary to implement the institutional
changes essential to economic growth (a capitalist system). The most critical difference is in the
sources of disequilibrium in the system which induced change. In the Marxian model it is technological
change. In our model it is the
change in relative prices and expansion in the size of the
market.
17
The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002