The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002
Douglass C. North
Institutional Change and Economic
Development
The Journal of Economic
History
Volume 31, Issue 1
The Tasks of Economic History
Mar., 1971,
118-125.
Index
The Voluntary vs. Government
Choice
The Fundamental Rules of the Game
HHC: titling
added
THE meteoric rise of the new economic history reflects
the fact that historians abhor a vacuum and sometimes it seems to reflect an
even baser instinct that any theory is better than no theory. Of course, any explanation always uses
theory; however, it was usually implicit and frequently a bouillabaisse in which
Marx, Veblen and the German historical school floated around in as equally
indigestible lumps. But the
combination of an internally consistent paradigm based on a few simple
assumptions and the mysteries of econometrics simply overwhelmed the older
historian, as much as anything else, because he could not understand the rules
of the game, much less play it. But
even while the new breed was destroying one traditional explanation after
another, the traditional historian even in retreat kept muttering over and over,
“But you are destroying the existing myths without replacing them. Soon there
will be no explanation - no economic history - just an immense heap of numbers.”
And sometimes, plaintively from the
left flank of the retreating historians, there would come the cry, “But
institutions ARE important!”
With that metaphoric mix behind me, let me become a
little more serious. The tools that
the new economic historian inherited from the economist were not intended to
deal with long-run economic change as twenty-five years of grouping by the
economist concerned with development should attest. The economist not only accepted tastes,
technology, and population as given, but also he accepted equally the current
basic ground rules within which both market and non-market decisions were made.
For that matter, the theory did not
recognize the possibility of making economic decisions via the political
process. Information was assumed to
be perfect and costless.
That is an awesome collection of deficiencies. Before we begin to see what we can do
about remedying them, we should keep in mind that “old saw” about not throwing
the baby out with the bathwater. Even with all their strictures, the tools
of the economist have proven their worth as the results of the new economic
historians clearly attest. What we
need is a body of theory which encompasses the traditional models of the
economist and both widens its scope and allows us to include an explanation of
the formation, mutation and
I am indebted to my colleague Robert L. Higgs for helpful
comments on an earlier draft of this paper.
118
decay of organizational forms within which man
cooperates or competes.
A beginning has been made. It has been primarily the work of
economists (and a few political scientists) in extending the paradigm to
encompass information, risk, externalities and non-market decision making. It is not my task in this essay to review
this literature but rather to show its promise and limitations for the economic
historian. 1 It will be
evident from the discussion below that the implications are revolutionary, and
it will be equally evident that we have also opened a Pandora’s
Box.
Let us begin on a positive note. Briefly stated, the model specifies the
process by which an action group (an individual or group) perceive that some new
form of organization (institutional arrangement) will yield a stream of benefits
which makes it profitable to undergo the costs of innovating this new
organizational form. These new
arrangements have typically been profitable to realize potential economies of
scale, reduce information costs, spread risk, and internalize externalities.
2 These institutional arrangements account for a vast array of the
“economic institutions” with which economic historians have traditionally been
concerned. However, the formation
(and mutation and decay) of these organizational forms can now be an integral
part of the economic analysis rather than a descriptive addition to the
analysis. Moreover, since a great
many were realizable without substantial redistribution of income, their
formation is at least in principle predictable from the model. Perhaps even more significant than the
ability to integrate economic analyses and institutional formation is the
implication of this theoretical model for the study of productivity increase.
Economic historians have focused on
technological change as the source of growth but
1. These extensions of economic theory have been applied
to economic history in two recent articles: Lance E. Davis and Douglass C.
North, “Institutional Change and American Economic Growth: A First Step Towards
a Theory of Innovation,” The Journal of Economic History (March
1970), pp. 131-149 [hereafter cited as,
2. For an exposition of the model and the sources of
disequilibrium which change the benefits and the costs to make it worthwhile to
innovate these institutional arrangements, see
119
the development of institutional arrangements from the
above mentioned sources are a major historical source of the improvement in the
efficiency of product and factor markets. The development of more efficient
economic organization is surely as important a part of the growth of the Western
World as is the development of technology, and it is time it received equal
attention. 3 The few cases of which I am aware that have attempted to
measure productivity change attributable to improving economic organization
certainly support this contention.
4
Yet not all of the potentially “productive”
institutional arrangements are so predictable. If such potentially new organizational
forms involve income redistribution so that there are substantial losers as well
as gainers, and the losers are not compensated, then the outcome is
indeterminate. We cannot tell, a
priori, whether the losers will be able to thwart the new arrangement or
not. Yet, despite this severe
stricture, we can at least expect that such potential profits will lead to
efforts to form such an institutional arrangement, even though we cannot predict
the outcome. 5
Institutional arrangements to realize gains from the
above mentioned sources were organizational innovations in which total output
was increased as a result of the improvement in productivity. Yet, not all institutional arrangements
are of this type. It has been
equally profitable, and frequently more rewarding, to devise arrangements to
redistribute income. In such cases,
output is not increased and more frequently total output falls. Institutional arrangements of this type
necessarily involve coercion and since government is the only legal source of
coercion, more often than not, they are a product of legislation or government
fiat. The ability of voluntary
associations to redistribute income usually requires that they be able to
effectively limit entry in a product or factor market. This entails overt or tacit government
coercive support such as trade unions and the
3. The two forces of technology and institutional
innovation are frequently interdependent since new technology frequently was the
source of disequilibrium which made it profitable to innovate an institutional
arrangement.
4. Douglass C. North, “Productivity Change in Ocean
Shipping 1600-1850,” Journal of Political Economy (September-October
1968), pp. 953-970; also, in the Chapter on Service Industries, we have
attempted to measure the changing organizational efficiency of the cotton trade
in the nineteenth century. Davis and North, Change and Growth, ch.
ix.
5. Since almost all institutional arrangements involve
some income redistribution, the likelihood of their realization is going to be
affected by the size and distribution of losses. Davis and North, Change and Growth,
chapter ii.
121
American Medical Association have enjoyed. Some redistributive institutional
arrangements may develop outside of, or in spite of, the government such as some
of the activities of claims clubs in the nineteenth century or in modern times
the Mafia. 6
The Voluntary
vs. Government Choice
The choice between innovating institutional arrangements
of a voluntary form or through government raises a number of issues and many of
them are still unresolved. We do
observe that both productive and redistributive (and combinations of both)
institutional arrangements may be of either type although we noted that if
substantial losses were imposed on individuals or groups in society that
government coercion was involved directly or by delegation. The relative benefits of governmental
versus voluntary institutional arrangements have varied over time with changes
in the coercive power of government and changes in the costs of getting “stuck”
with government decisions.
7
The distinction between voluntary associations and
governmental ones is more complicated than we had originally conceived it to be.
The usual distinction is that
voluntary associations are governed by a unanimity rule and withdrawal is
voluntary whereas governmental organizations exist by an arbitrary decision rule
(usually a simple majority), withdrawal is not permissible and the government is
uniquely endowed with coercive power.
In fact, voluntary association may not operate under a unanimity rule.
Individuals in the association may
disagree with the association’s policies, but as long as the costs of withdrawal
exceed the costs of the decision, they will remain. Moreover, one may withdraw from a
government arrangement by migration. To make the distinction even muddier,
many voluntary associations are profitable only because they have the coercive
power of legal sanction behind them.
The advantages of the corporation are derived from its legal
characteristics. In fact, we find
historically that institutional arrangements run the whole gamut from “pure”
voluntary to mixed to “pure” governmental. In order to clarify further the basic
characteristics of institutional arrangements, the economic historian is going
to have to become deeply immersed in legal history. Unfortunately, since he will seldom
find
6. In our forthcoming book, Lance Davis and I explore
briefly the source of success of extra-legal or illegal institutional
arrangements in the history of American land policy.
7. In our forthcoming book, Lance Davis and I explore the
changing public/private mix over the past one hundred and eighty years (chapter
xi).
121
legal historians asking the questions he wants answered,
he will not find complete satisfaction in the existing
literature.
Before we proceed further, we should note two
limitations to our model of the formation of secondary institutional
arrangements. Our model is
predicated on profit maximization in which the guiding force in the innovation
of an institutional arrangement is the private profitability to the primary
action group and the model also assumes that individuals will acquire the
necessary information to act “rationally” as long as it is profitable for them
to do so (that is, until the benefits and costs are equated at the margin).
Yet, neither assumption always
holds. Individuals and groups have
devised institutional arrangements for the benefit of others. Social reformers endeavor to
redistribute income in favor of low-income groups. The negative income tax for example has
been promoted, for the most part, by individuals and groups who stand to lose
from its enactment.
Secondly, people frequently act in terms of general
ideological positions rather than incur the costs of acquiring information on a
particular issue even when it would pay them to do so. Thus, they react as liberals,
conservatives, radicals, or reactionaries. Ideologies are a way of economizing on
the costs of information and therefore are in general a rational response to the
costs of information about the broad range of issues that face them. But this does lead people, frequently, to
act against their own self-interests about a particular issue. Thus the weight of existing evidence
would suggest that it is not in the interests of a poor black to favor higher
minimum wage legislation even though it is likely a substantial majority of them
do favor such legislation.
The Fundamental Rules of the
Game
Up until now we have been talking about secondary
institutional arrangements which are innovated in the context of the
“fundamental rules of the game.” These basic ground rules consist of the
decision rules that govern the making of non-market decisions and the structure
of property rights that define and specify competitive and cooperative
relationships in the market place. These basic ground rules may exist as a
written constitution, as a body of written law, by custom, or as a combination
of all three. There is usually a
formal and typically very costly procedure for amending those that are in
written form.
What is the relationship between secondary and
fundamental institutional arrangements? While there is typically some overlap
between them, the most obvious difference is that the latter are
far
122
more costly to alter than the former, and that
historically this has been the intention of framers of constitutions as well as
the “raison d’etre” for the sanctity with which such basic customs are
regarded.
The economic changes which produce disequilibrium in the
system and therefore profitable opportunities to innovate secondary
institutional arrangements may ultimately induce changes in the fundamental
institutional environment, but the obstacles to devising a precise model to
predict such changes are formidable. Let me illustrate from a forthcoming
paper which my colleague, Robert Thomas, and I have just completed .8
The growth of population in the twelfth and thirteenth
centuries led to general diminishing returns in much of Western Europe, and in
consequence a relative rise in the value of land. The consequence was to raise the rate of
return for landholders, eliminating the common property aspects of landholding
that characterized feudal land law. The result was the innovation of a host
of secondary institutional arrangements devised to try to get around the
fundamental feudal law. In the case
of England the cumulative effect of these “actions” was to lead to a series of
changes in the fundamental law which between the thirteenth and seventeenth
centuries fundamentally altered land law to permit, in effect, fee-simple
absolute ownership.
9 Yet the response lags varied widely from country to
country, and in the case of
When we turn to American history we find that formal
changes in the Constitution through amendment has not only been very costly, as
its framers intended, but also has not been the main avenue by which changes in
the fundamental institutional structure have occurred, which its framers may not
have intended. It is not that
changing Supreme Court interpretations of the Constitution are not related to
the changing economic environment; it is simply that the lagged response defies
any simple explanation. I would
suggest three tentative propositions for further research.
1. With a rise in the benefits to be gained from
altering the fundamental institutional environment (as a result of some
disequilibrating economic changes), secondary institutional arrangements will be
innovated at a much lower cost than changing the
fundamental
8. “The Rise and Fall of the Manorial System: A Theoretical
Model.”
9. Although, it wasn’t until the 1920’s that some of the
formal language of feudal land law was finally eliminated.
123
institutional arrangements. These secondary institutional
arrangements will attempt to capture these potential profits by circumventing
(and in some cases by illegally violating) the strictures of the basic decision
rules. A cumulation of such
secondary institutional arrangements will lower the cost of attempting to effect
a changing in the basic decision rules.
2. Since changes in the basic decision rules typically
redistribute wealth, income, and political power, we cannot make a predictive
statement about the outcome given the present state of the
theory.
3. Historically, we do observe that when conflict arose
amongst groups over fundamental institutional arrangements, there was an
incentive for the group that achieved the power to make the changes to impound
these new rules in a written constitutional document which was very costly to
alter. This would occur if a group
envisions that its decision-making ability with respect to the basic decision
rules might not be permanent. From
the Magna Charta to the U. S. Constitution, the purpose was to specify a set of
new fundamental rules as far removed from capricious or individual alteration as
possible.
It is one question to ask how the basic institutional
environment is formed and modified. We need to know much more. It is still another question to ask what
the consequences are of any set of basic decision rules. While scholars have devoted (and quite
rightly so) a great deal of attention to the growth of the political decision
rules, their primary attention has been for its consequences for representative
government. However, the
consequences of both the political and economic decision rules for their effect
on economic growth has, until quite recently, been neglected. Yet, and I shall state it baldly, it is
my conviction that economists have misdirected their efforts in the past
twenty-five years in their search for the explanation of economic growth. The answer does not lie in the narrow
economic confines of their models of capital formation or any of the other
“strategic” variables that have variously come to the fore; the answer lies in
the characteristics of the basic institutional environment and the degree to
which these basic ground rules are enforced. If these rules lower the cost and raise
the benefits of institutional arrangements which redistribute income relative to
those that encourage (by profitable incentive) institutional arrangements which
increase output, then that society will devote its energies accordingly. If, on the other hand, the reverse is
correct, then eco-
124
nomic growth will occur. This is hardly a new finding since it is
the essence of what
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The Competitiveness of Nations
in a Global Knowledge-Based Economy
June 2002