The Competitiveness of Nations in a Global Knowledge-Based Economy
Douglas C. North *
Economic Performance
Through Time †
American Economic Review,
84 (3) June 1994, 359-368
|
Content I – Introduction II – Institutions &
Economic Performance III – Institutional Change IV – Cognitive Science
Approach to Human Learning V – Institutional/Cognitive Approach to Economic
History VI – Implications for Understanding the Past VII - Policy Implications T itles added to numbering by HHC |
Introduction
Economic history is about
the performance of economies through time. The objective of research in the field is
not only to shed new light on the economic past, but also to contribute to
economic theory by providing an analytical framework that will enable us to
understand economic change. A
theory of economic dynamics comparable in precision to general equilibrium
theory would be the ideal tool of analysis. In the absence of such a theory we can
describe the characteristics of past economies, examine the performance of
economies at various times, and engage in comparative static analysis; but
missing is an analytical understanding of the way economies evolve through
time.
A theory of economic
dynamics is also crucial for the field of economic development. There is no mystery why the field of
development has failed to develop during the five decades since the end of World
War II. Neoclassical theory is
simply an inappropriate tool to analyze and prescribe policies that will induce
development. It is concerned with
the operation of markets, not with how markets develop. How can one prescribe policies when one
doesn’t understand how economies develop? The very methods employed by neoclassical
economists have dictated the subject matter and militated against such a
development. That theory in the
pristine form that gave it mathematical precision and elegance modeled a
frictionless and static world. When
applied to economic history and development it focused on technological
development and more recently human-capital investment but ignored the incentive
structure embodied in institutions that determined the extent of societal
investment in those factors. In the
analysis of economic performance through time it contained two erroneous
assumptions: (i) that institutions do not matter and (ii) that time does not
matter.
This essay is about
institutions and time. It does not
provide a theory of economic dynamics comparable to general equilibrium theory.
We do not have such a
theory. [1] Rather it
provides the initial scaffolding of an analytical framework capable of
increasing our understanding of the historical evolution of economies and a
necessarily crude guide to policy in the ongoing task of improving the economic
performance of economies. The
analytical framework is a modification of neoclassical theory. What it retains is the fundamental
assumption of scarcity and hence competition and the analytical tools of
microeconomic theory. What it
modifies is the rationality assumption. What it adds is the dimension of
time.
Institutions form the
incentive structure of a society, and the political and economic institutions,
in consequence, are the underlying determinants of economic performance. Time as it relates to economic
and
† This article is the lecture Douglass C North delivered in
* Department of Economics,
1. In fact such a theory is
unlikely. I refer the reader to
Frank Hahn’s prediction about the future of economic theory (Hahn, 1991).
359
societal change is the
dimension in which the learning process of human beings shapes the way
institutions evolve. That is, the
beliefs that individuals, groups, and societies hold which determine choices are
a consequence of learning through time - not just the span of an individual’s
life or of a generation of a society, but the learning embodied in individuals,
groups, and societies that is cumulative through time and passed on
intergenerationally by the culture of a society.
The next two sections of
this essay summarize the work I, and others, have done on the nature of
institutions and the way they affect economic performance (Section II) and then
characterize the nature of institutional change (Section III). [2] The remaining four sections describe a
cognitive-science approach to human learning (Section IV); provide an
institutional/cognitive approach to economic history (Section V); indicate the
implications of this approach for improving our understanding of the past
(Section VI); and finally suggest implications for current development policies
(Section VII).
II
Institutions & Economic Performance
Institutions are the
humanly devised constraints that structure human interaction. They are made up of formal constraints
(e.g., rules, laws, constitutions), informal constraints (e.g., norms of
behavior, conventions, self-imposed codes of conduct), and their enforcement
characteristics. Together they
define the incentive structure of societies and specifically
economies.
Institutions and the
technology employed determine the transaction and transformation costs that add
up to the costs of production. It
was Ronald Coase (1960) who made the crucial connection between institutions,
transaction costs, and neoclassical theory. The neoclassical result of efficient
markets only obtains when it is costless to transact. Only under the conditions of costless
bargaining will the actors reach the solution that maximizes aggregate income
regardless of the institutional arrangements. When it is costly to transact, then
institutions matter. And it is
costly to transact. John J. Wallis
and North (1986) demonstrated in an empirical study that 45 percent of
U.S. GNP was devoted to the transaction sector in 1970. Efficient markets are created in the real
world when competition is strong enough via arbitrage and efficient information
feedback to approximate the Coase zero-transaction-cost conditions and the
parties can realize the gains from trade inherent in the neoclassical
argument.
But the informational and
institutional requirements necessary to achieve such efficient markets are
stringent. Players must not only
have objectives, but know the correct way to achieve them. But how do the players know the correct
way to achieve their objectives? The instrumental rationality answer is
that, even though the actors may initially have diverse and erroneous models,
the informational feedback process and arbitraging actors will correct initially
incorrect models, punish deviant behavior, and lead surviving players to correct
models.
An even more stringent
implicit requirement of the discipline-of-the-competitive-market model is that,
when there are significant transaction costs, the consequent institutions of the
market will be designed to induce the actors to acquire the essential
information that will lead them to correct their models. The implication is not only that
institutions are designed to achieve efficient outcomes, but that they can be
ignored in economic analysis because they play no independent role in economic
performance.
These are stringent
requirements that are realized only very exceptionally. Individuals typically act on incomplete
information and with subjectively derived models that are frequently erroneous;
the information feedback is typically insufficient to correct these subjective
models. Institutions are not
necessarily or even usually created to be socially efficient; rather they, or at
least the
2. These two sections briefly summarize material contained in North (1990a).
360
formal rules, are created
to serve the interests of those with the bargaining power to create new
rules. In a world of zero
transaction costs, bargaining strength does not affect the efficiency of
outcomes; but in a world of positive transaction costs it
does.
It is exceptional to find
economic markets that approximate the conditions necessary for efficiency. It is impossible to find political
markets that do. The reason is
straightforward. Transaction costs
are the costs of specifying what is being exchanged and of enforcing the
consequent agreements. In economic
markets what is being specified (measured) is the valuable attributes - the
physical and property-rights dimensions - of goods and services or the
performance of agents. While
measurement can frequently be costly, there are some standard criteria: the
physical dimensions have objective characteristics (size, weight, color, etc.),
and the property-rights dimensions are defined in legal terms. Competition also plays a critical role in
reducing enforcement costs. The
judicial system provides coercive enforcement. Still, economic markets in the past and
present are typically imperfect and be-set by high transaction
costs.
Measuring and enforcing agreements in political markets is far more difficult. What is being exchanged (between constituents and legislators in a democracy) is promises for votes. The voter has little incentive to become informed because the likelihood that one’s vote matters is infinitesimal; further, the complexity of the issues produces genuine uncertainty. Enforcement of political agreements is beset by difficulties. Competition is far less effective than in economic markets. For a variety of simple, easy-to-measure, and important-to-constituent-well-being policies, constituents may be well informed, but beyond such straightforward policy issues ideological stereotyping takes over and (as I shall argue below in Section IV) shapes the consequent performance of economies. [3] It is the polity that defines and enforces property rights, and in consequence it is not surprising that efficient economic markets are so exceptional.
III
Institutional Change
It is the interaction
between institutions and organizations that shapes the institutional evolution
of an economy. If institutions are
the rules of the game, organizations and their entrepreneurs are the
players.
Organizations are made up
of groups of individuals bound together by some common purpose to achieve
certain objectives. Organizations
include political bodies (e.g., political parties, the Senate, a city council,
regulatory bodies), economic bodies (e.g., firms, trade unions, family farms,
cooperatives) social bodies (e.g., churches, dubs, athletic associations), and
educational bodies (e.g., schools, universities, vocational training
centers).
The organizations that come
into existence will reflect the opportunities provided by the institutional
matrix. That is, if the
institutional framework rewards piracy then piratical organizations will come
into existence; and if the institutional framework rewards productive activities
then organizations – firms - will come into existence to engage in productive
activities.
Economic change is a
ubiquitous, ongoing, incremental process that is a consequence of the choices
individual actors and entrepreneurs of organizations are making every day. While the vast majority of these
decisions are routine (Richard Nelson and Sidney G. Winter, 1982), some involve
altering existing “contracts” between individuals and organizations. Sometimes that recontracting can be
accomplished within the existing structure of property rights and political
rules; but sometimes new contracting forms require an alteration in the rules.
Equally, norms of behavior that
guide exchanges will gradually be modified or wither away. In both instances, institutions are being
altered.
Modifications occur because
individuals perceive that they could do better by restructuring exchanges
(political or eco-
3. See the author’s “A Transaction Cost Theory of Politics” for a transaction-cost approach to the relative inefficiency of political markets (North, 1990b).
361
nomic). The source of the changed perceptions may
be exogenous to the economy - for instance a change in the price or quality of a
competitive product in another economy that alters perceptions of entrepreneurs
in the given economy about profitable opportunities. But the most fundamental long-run source
of change is learning by individuals and entrepreneurs of
organizations.
While idle curiosity will
result in learning, the rate of learning will reflect the intensity of
competition among organizations. Competition, reflecting ubiquitous
scarcity, induces organizations to engage in learning to survive. The degree of competition can and does
vary. The greater the degree of
monopoly power, the lower is the incentive to
learn.
The speed of economic change is a function of the rate of learning, but the direction of that change is a function of the expected payoffs to acquiring different kinds of knowledge. The mental models that the players develop shape perceptions about the payoffs.
IV
Cognitive Science Approach to Human
Learning
It is necessary to
dismantle the rationality assumption underlying economic theory in order to
approach constructively the nature of human learning. History demonstrates that ideas,
ideologies, myths, dogmas, and prejudices matter; and an understanding of the
way they evolve is necessary for further progress in developing a framework to
understand societal change. The
rational-choice framework assumes that individuals know what is in their
self-interest and act accordingly. That may be correct for individuals
making choices in the highly developed markets of modern economies, [4] but it is patently false in making choices under conditions of uncertainty
- the conditions that have characterized the political and economic choices that
shaped (and continue to shape) historical change.
Herbert Simon (1986 pp.
S210-11) has stated the issues succinctly:
If.. .we
accept the proposition that both the knowledge and the computational power of
the decisionmaker, are severely limited, then we must distinguish between the
real world and the actor’s perception of it and reasoning about it. That is to say we must construct a theory
(and test it empirically) of the process of decision. Our theory must include not only the
reasoning processes but also the processes that generated the actor’s subjective
representation of the decision problem, his or her
frame.
The analytical framework we
must build must originate in an understanding of how human learning takes place.
We have a way to go before we can
construct such a theory, but cognitive science has made immense strides in
recent years - enough strides to suggest a tentative approach that can help us
understand decision-making under
uncertainty. [5
Learning entails developing
a structure by which to interpret the varied signals received by the senses.
The initial architecture of the
structure is genetic, but the subsequent scaffolding is a result of the
experiences of the individual. The
experiences can be classified into two kinds - those from the physical
environment and those from the socio-cultural linguistic environment. The structures consist of categories -
classifications that gradually evolve from earliest childhood to organize our
perceptions and keep track of our memory of analytic results and experiences.
Building on these classifications,
we form mental models to explain and interpret the environment - typically
in
4.
However, see the anomalies even here in the studies by Amos Tversky and Daniel
Kabneman (1986) and others (Robin M. Hogarth and Melvin W. Reder,
1986).
5. See
John H. Holland et al. (1986) for an excellent introduction to the
cognitive-science literature.
362
ways relevant to some goal.
Both the categories and the mental
models will evolve, reflecting the feedback derived from new experiences:
feedback that sometimes strengthens our initial categories and models or may
lead-to modifications - in short, learning. Thus the mental models may be continually
redefined with new experiences, including contact with others’
ideas.
At this juncture the
learning process of human beings diverges from that of other animals (such as
the sea slug - a favorite research subject of cognitive scientists) and
particularly diverges from the computer analogy that dominated early studies of
artificial intelligence. The mind
appears to order and reorder the mental models from their special-purpose
origins to successively more abstract forms so that they become available to
process other information. The term
used by Andy Clark and Annette Karmiloff-Smith (1993) is “representational
redescription.” The capacity to
generalize from the particular to the general and to use analogy is a part of
this redescription process. It is
this capacity that is the source not only of creative thinking, but also of the
ideologies and belief systems that underlie the choices humans
make. [6
A common cultural heritage
provides a means of reducing the divergence in the mental models that people in
a society have and constitutes the means for the intergenerational transfer of
unifying perceptions. In pre-modern
societies cultural learning provided a means of internal communication; it also
provided shared explanations for phenomena outside the immediate experiences of
the members of society in the form of religions, myths, and dogmas. Such belief structures are not, however,
confined to primitive societies, but are an essential part of modern societies
as well.
Belief structures get
transformed into societal and economic structures by institutions - both formal
rules and informal norms of behavior. the relationship between mental models and
institutions is an intimate one. Mental models are the internal
representations that individual cognitive systems create to interpret the
environment; institutions are the external (to the mind) mechanisms individuals
create to structure and order the environment.
Institutional/Cognitive Approach to
Economic History
There is no guarantee that
the beliefs and institutions that evolve through time will produce economic
growth. Let me pose the issue that
time presents us by a brief institutional/cognitive story of long-run
economic/political change.
As tribes evolved in
different physical environments, they developed different languages and, with
different experiences, different mental models to explain the world around them.
The languages and mental models
formed the informal constraints that defined the institutional framework of the
tribe and were passed down intergenerationally as customs, taboos, and myths
that provided cultural continuity. [7
With growing specialization
and division of labor, the tribes evolved into polities and economies; the
diversity of experience and learning produced increasingly different societies
and civilizations with different degrees of success in solving the fundamental
economic problems of scarcity. The
reason is that as the complexity of the environment increased as human beings
became increasingly interdependent, more complex institutional structures were
necessary to capture the potential gains from trade. Such evolution requires that the society
develop institutions that will permit anonymous, impersonal exchange across time
and space. To the extent that the
culture and local experiences had produced diverse institutions and belief
systems with respect to the gains from
6.
Ideologies are shared frameworks of mental models that groups of individuals
possess that provide both an interpretation of the environment and a
prescription as to how that environment should be
ordered.
7. Ronald
Heiner (1983), in a path-breaking article, not only made the connection between
the mental capacities of humans and the external environment, but suggested the
implications for arresting economic progress.
363
such cooperation, the likelihood of creating the necessary institutions to capture the gains from trade of more complex contracting varied. In fact, most societies throughout history got “stuck” in an institutional matrix that did not evolve into the impersonal exchange essential to capturing the productivity gains that came from the specialization and division of labor that have produced the Wealth of Nations.
The key to the foregoing
story is the kind of learning that the individuals in a society acquired through
time. Time in this context entails
not only current experiences and learning, but also the cumulative experience of
past generations that is embodied in culture. Collective learning - a term used by
Friedrich A. Hayek - consists of those experiences that have passed the slow
test of time and are embodied in our language, institutions, technology, and
ways of doing things. It is “the
transmission in time of our accumulated stock of knowledge” (Hayek, 1960 p. 27).
It is culture that provides the key
to path dependence - a term used to describe the powerful influence of the past
on the present and future. The
current learning of any generation takes place within the context of the
perceptions derived from collective learning. Learning then is an incremental process
filtered by the culture of a society which determines the perceived payoffs, but
there is no guarantee that the cumulative past experience of a society will
necessarily fit them to solve new problems. Societies that get “stuck” embody belief
systems and institutions that fail to confront and solve new problems of
societal complexity.
We need to understand a great deal more about the cumulative learning of a society. The learning process appears to be a function of (i) the way in which a given belief structure filters the information derived from experiences and (ii) the different experiences confronting individuals and societies at different times. The perceived rate of return (private) may be high to military technology (in medieval
The incentives to acquire pure knowledge, the essential underpinning of modern economic growth, are affected by monetary rewards and punishments; they are also fundamentally influenced by a society’s tolerance of creative developments, as a long list of creative individuals from Galileo to
Incentives embodied in
belief systems as expressed in institutions determine economic performance
through time, and however we wish to define economic performance the historical
record is clear. Throughout most of
history and for most societies in the past and present, economic performance has
been anything but satisfactory. Human beings have, by trial and error,
learned how to make economies perform better; but not only has this learning
taken ten millennia (since the first economic revolution), it has still escaped
the grasp of almost half of the world’s population. Moreover the radical improvement in
economic performance, even when narrowly defined as material well-being, is a
modern phenomenon of the last few centuries and confined until the last few
decades to a small part of the world. Explaining the pace and direction of
economic change throughout history presents a major
puzzle.
Let us represent the human experience to date as a 24-hour clock in which the beginning consists of the time (apparently in
364
utes, humans remained
hunters and gatherers, and while population grew, it did so at a very slow
pace.
Now if we make a new
24-hour dock for the time of civilization - the 10,000 years from development of
agriculture to the present - the pace of change appears to be very slow for the
first 12 hours, although our archeological knowledge is very limited. Historical demographers speculate that
the rate of population growth may have doubled as compared to the previous era
but still was very slow. The pace
of change accelerates in the past 5,000 years with the rise and then decline of
economies and civilizations. Population may have grown from about 300
million at the time of Christ to about 800 million by 1750 - a substantial
acceleration as compared to earlier rates of growth. The last.250 years - just 35 minutes on
our new 24-hour clock - are the era of modern economic growth, accompanied by a
population explosion that now puts world population in excess of 5
billion.
If we focus now on the last 250 years, we see that growth was largely restricted to
Not only has the pace varied over the ages; the change has not been unidirectional. That is not simply a consequence of the decline of individual civilizations; there have been periods of apparent secular stagnation - the most recent being the long hiatus between the end of the Roman Empire in the West and the revival of Western Europe approximately 500 years later.
VI
Implications for Understanding the Past
What can an
institutional/cognitive approach contribute to improving our understanding of
the economic past? First of all it
should make sense out of the very uneven pattern of economic performance
described in the previous section. There is nothing automatic about the
evolving of conditions that will permit low-cost transacting in the impersonal
markets that are essential to productive economies. Game theory characterizes the issue.
Individuals will usually find it
worthwhile cooperating with others in exchange when the play is repeated, when
they possess complete information about the other players’ past performance, and
when there are small numbers of players. Cooperation is difficult to sustain when
the game is not repeated (or there is an endgame), when information about the
other players is lacking, and when there are large numbers of players. Creating the institutions that will alter
the benefit/cost ratios in favor of cooperation in impersonal exchange is a
complex process, because it not only entails the creation of economic
institutions, but requires that they be undergirded by appropriate political
institutions.
We are just beginning to
explore the nature of this historical process. The remarkable development of Western
Europe from relative backwardness in the 10th century to world economic hegemony
by the 18th century is a story of a gradually evolving belief system in the
context of competition among fragmented political/economic units producing
economic institutions and political structure that produced modern economic
growth. [8] And even within
Western Europe there were successes (the Netherlands and England) and failures
(Spain and Portugal) reflecting diverse external environmental
experiences. [9
Second,
institutional/cognitive analysis should explain path dependence, one of the
remarkable regularities of history. Why do economies once on a path of growth
or stagnation tend to persist? Pioneering work on this subject is
beginning to give us in-sights into the sources of path dependence (Brian
Arthur, 1989; Paul David, 1985). But there is much that we still do not
know. The rationality assumption of
neoclassical theory would suggest that political entrepreneurs of stagnating
economies could simply alter the rules and change the direction of failed
economies. It is not that rulers
have been
8 See North
and Robert P. Thomas (1973), E L Jones (1981), and Nathan Rosenberg and L E.
Birdzell (1986) for accounts of this growth.
9 See part III of North (1990a) for a brief discussion of the contrasting paths of the
365
unaware of poor performance. Rather, the difficulty of turning economies around is a function of the nature of political markets and, underlying that, the belief systems of the actors. The long decline of
Third, this approach will
contribute to our understanding of the complex interplay between institutions,
technology, and demography in the overall process of economic change. A complete theory of economic performance
would entail such an integrated approach to economic history. We certainly have not put all the pieces
together yet. For example, Robert
Fogel’s path-breaking work on demographic theory [11] and its
historical implications for reevaluating past economic performance have yet to
be integrated fully with institutional analysis. The same is true for technological
change. The important contributions
of Nathan Rosenberg (1976) and Joel Mokyr (1990) exploring the impetus for and
consequences of technological change have ongoing implications which need to be
integrated with institutional analysis. An essay by Wallis and North (1994) is a
beginning at integrating technological and institutional analysis. But a major task of economic history is
to integrate these separate strands of research.
VII
Policy Implications
We cannot account for the rise and decline of the
1. It is the admixture of
formal rules, informal norms, and enforcement characteristics that shapes
economic performance. While the
rules may be changed overnight, the informal norms usually change only
gradually. Since it is the norms
that provide “legitimacy” to a set of rules, revolutionary change is never as
revolutionary as its supporters desire, and performance will be different than
anticipated. And economies that
adopt the formal rules of another economy will have very different performance
characteristics than the first economy because of different informal norms and
enforcement. The implication is
that transferring the formal political and economic rules of successful Western
market economies to third-world and Eastern European economies is not a
sufficient condition for good economic performance. Privatization is not a panacea for
solving poor economic performance.
2. Polities significantly shape economic performance because they define and enforce the economic rules. Therefore an essential part of development policy is the creation of polities that will create and enforce efficient property rights. However, we know very little about how to create such polities because the new political economy (the new institutional economics applied to politics) has been largely focused on the
10. DeVries (1976 p. 28) has a description of the bizarre remedies proposed by a royal commission to reverse
11. See Fogel’s (1994) accompanying Nobel lecture.
365
economic growth can occur
in the short run with autocratic regimes, long-run economic growth entails the
development of the rule of law. (e)
Informal constraints (norms, conventions, and codes of conduct) favorable to
growth can sometimes produce economic growth even with unstable or adverse
political rules. The key is the
degree to which such adverse rules are enforced.
3. It is adaptive rather
than allocative efficiency which is the key to long-run growth. Successful political/economic systems
have evolved flexible institutional structures that can survive the shocks and
changes that are a part of successful evolution. But these systems have been a product of
long gestation. We do not know how
to create adaptive efficiency in the short run.
We have just set out on the
long road to achieving an understanding of economic performance through time.
The ongoing research embodying new
hypotheses confronting historical evidence will not only create an analytical
framework enabling us to understand economic change through time; in the process
it will enrich economic theory, enabling it to deal effectively with a wide
range of contemporary issues currently beyond its ken. The promise is there. The recognition of that promise by the
Nobel Committee should be the essential spur to move us on down that
road.
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