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.
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.
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
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.
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 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).
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.
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
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
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.
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-
nomic growth will occur. This is hardly a new finding since it is
the essence of what