Institutions and economic theory.

North, Douglass C.

It is surely appropriate that the John R. Commons lecture would someday be given on the subject of Institutions. Anyone who goes back to read The Legal Foundations of Capitalism (1924) will find that Commons anticipated much of the evolving literature of the new Institutional economics. He and the other practitioners of the old institutional economics - Veblen, Mitchell, Ayres - gave us imaginative insights, perceptive description, quantitative measurement. They did not, however, give us theory. And it is the development of an integrated, systematic body of the theory that not only is the hallmark of a discipline, but also provides the essential scaffolding for the further development and progress of a discipline. The new Institutional economics remedies (albeit imperfectly) that theory defect. Moreover in contrast to the many earlier attempts to overturn or replace neo-classical theory, the new institutional economics builds on, modifies, and extends neo-classical theory to permit it to come to grips and deal with an entire range of issues heretofore beyond its ken. What it retains and builds on is the fundamental assumption of scarcity and hence competition - the basis of the choice theoretic approach that underlies micro-economics. What it abandons is instrumental rationality - the assumption of neo-classical economics that has made it an institution-free theory. Herbert Simon has accurately summarized the implications of such an assumption as follows:

If we accept values as given and constant, if we postulate an objective description of the worlds as it really is, and if we assume that the decisionmaker's computational powers are unlimited then two important consequences follow. First we do not need to distinguish between the real world and the decisionmaker's perception of it: her or she perceives the world as it really is. Second we can predict the choices that will be made by a rational decisionmaker entirely from our knowledge of the real world and without a knowledge of the decisionmaker's perceptions or modes of calculation (we do, of course, have to know his or her utility function). (Simon, 1986, p. s 210)

Institutions are unnecessary in a world of instrumental rationality; ideas and ideologies don't matter; and efficient markets - both economic and political - characterize economics.

In fact, we have incomplete information and limited mental capacity by which to process information. Human beings, in consequence, impose constraints on human interaction in order to structure exchange. There is no implication that the consequent institutions are efficient. In such a world ideas and ideologies play a major role in choices and transaction costs result in imperfect markets.

The place to begin a theory of institutions, therefore, is with a modification of the instrumental rationality assumption. We are still a long way from completely understanding how the mind processes information but cognitive science has made impressive strides in recent years.

The "mental models" individuals possess are in part culturally derived, partly acquired through experience, and partly non-culturally and non-locally learned. Culture consists of the intergenerational transfer of knowledge, values, and norms; and it varies radically among different ethnic groups and societies. Experience is "local" to the particular environment and therefore varies widely with different environments.(1) Consequently there is immense variation in mental models and in consequence different perceptions of the world and the way it "works." And even the formal learning that individuals acquire frequently consist of conflicting models by which we interpret the world around us.

The choices individuals make are going to reflect the mental constructs by which they process information and will vary with different mental constructs. Individuals do learn, and changes in mental models stem from outcomes inconsistent with expectations; but in Frank Hahn's words "there is a continuum of theories that agents can hold and act upon without ever encountering events which lead them to change their theories." (Hahn, 1987, p. 324) In consequence there is not one determinate equilibrium which will obtain; but multiple equilibria can occur.

Information processing by the actors as a result of the costliness of transacting underlies the information of institutions. At issue is not only the rationality postulate but the specific characteristics of transacting that prevent the actors from achieving the joint maximizations result of the zero transaction cost model. The costs of transacting arise because information is costly and asymmetrically held by the parties to exchange. The costs of measuring the multiple valuable dimensions of the goods or services exchanged or of the performance of agents, and the costs of enforcing agreements underlie transaction costs.(2)

Institutions are formed to reduce uncertainty in human exchange. Together with the technology employed they determined the costs of transacting (and producing). It was Ronald Coase (1973 and 1960) who made the crucial connection between institutions, transaction costs and neo-classical theory; a connection which even after three decades has not been completely understood by the economics profession. Let me state it baldly. The neo-classical result of efficient markets only obtains when it is costless to transact. When it is costly to transact, institutions matter. It is costly to transact; in fact a large part of national income is devoted to transacting.(3) Therefore institutions and specifically property rights are crucial determinants of the efficiency of markets. Coase was (and still is) concerned with the firm and resource allocation in the modern market economy; but his insight is the key to unraveling the tangled skein of the performance of economies over time, which is my primary concern as an economic historian.

Institutions and the way they evolve shape performance of economies over time. Let me provide several definitions that undergird five propositions that are the essential scaffolding of an analytical framework of institutional change.

Institutions are the rules of the game of a society or more formally are the humanly devised constraints the structure human interaction. They are composed of formal rules (statute law, common law, regulations), informal constraints (conventions, norms of behavior, and self imposed rules of behavior); and the enforcement characteristics of both.

Organizations are the players: group of individuals bound by a common purpose to achieve objectives. They include political bodies (political parties, the senate, a city council, a regulatory agency); economics bodies (firms, trade unions, family farms, cooperatives); social bodies (churches, clubs, athletic associations); and educational bodies (schools, colleges, vocational training centers).

The five propositions are: 1. The continuous interaction between institutions

and organizations in the economic

setting of scarcity and hence competition is

the key to institutional change. 2. Competition forces organizations to continually

invest in skills and knowledge to

survive. The kinds of skills and knowledge

individuals and their organizations acquire

will shape evolving perceptions about opportunities

and hence choices that will incrementally

alter institutions. 3. The institutional framework provides the

incentive that dictate the kind of skills and

knowledge perceived to have the maximum

pay-off. 4. Perceptions are derived from the mental

constructs of the players. 5. The economies of scope, complementarities,

and network externalities of an institutional

matrix make institutional change overwhelmingly

incremental and path dependent.

How does this new institutional approach fit in with neo-classical theory? It begins with the scarcity hence competition postulate; views economics as a theory of choice subject to constraints; employs price theory as an essential part of the analysis of institutions; and sees changes in relative prices as a major force inducing change in institutions.

How does this approach modify or extend neo-classical theory? In addition to a modification of the rationality postulate, it adds institutions as a critical constraint and analyzes the role of transaction costs as the connection between institutions and costs or production. It extends economic theory by incorporating ideas and ideologies into the analysis, modeling the political process as a critical factor in the performance of economies, as the source of the diverse performance of economies, and as the explanation for "inefficient" markets.

Let me expand on this last point - inefficient markets - because it highlights the major contribution that the new institutional economics can make to economics and economic history. Coase began his essay (1960) by arguing that when it is costless to transact, the efficient neo-classical competitive solution obtains. It does so because the competitive structure of efficient markets leads the parties to arrive costlessly at the solution that maximizes aggregate income regardless of the institutional arrangements. Now to the extent that these conditions are mimicked in the real world they are mimicked because 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 neo-classical argument.

But the informational and institutional requirements necessary to achieve that result are stringent. Players 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 the 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 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.

But these are stringent requirements that are realized only 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 formal rules are created to serve the interests of those with the bargaining power to create new rules. In a zero transaction cost world, bargaining strength does not affect the efficiency of outcomes, but in a world of positive transaction costs it does - and it thus shapes the direction of long run economic change.

It is exceptional to find economic markets that approximate the conditions necessary for efficiency. It is impossible to find political markets that do.(4) Because it is the polity that defines and enforces property rights, it is not surprising that efficient economic markets are exceptional. Moreover once an economy is on an "inefficient" path that produces stagnation it can persist (and historically has persisted) because of the nature of path dependence.

Institutional path dependence exists because of the network externalities, economies of scope, and complementarities that exist with a given institutional matrix. In everyday language the individuals and organizations with bargaining power as a result of the institutional framework have a crucial stake in perpetuating the system. Paths do get reversed (witness Argentina from growth to stagnation in the past half century or Spain the reverse since the 1950's). But reversal is a difficult process about which we know all to little - as witness the ongoing fumbling efforts at such reversal in central and eastern Europe. The reason is that we still know all too little about the dynamics of institutional change and particularly the interplay between economic and political markets.

All of this, therefore, does not add up to anything as elegant as a theory. A dynamic theory of economic change is the objective; but what we have so far is a set of definitions and principles and a structure that make up some of the essential scaffolding necessary to a theory of institutional change. What I said at the outset was that the intention which so far has only very imperfectly been realized is to develop a body of theory. But I take heart from Frank Hahn's recent prediction of "the Next Hundred Years" in economics in which he forecasts an end to theory of the |pure' sort. He maintains that"... radical changes in questions and methods are required if we are to deliver, not practical, but theoretically useful results. . . . Instead of theorems we shall need simulations, instead of simple transparent axioms there looms the likelihood of psychological, sociological, and historical postulates. These new roads will find willing and happy travelers, but it is unlikely that those with the temperament and facilities of mid-twentieth century theorists will find this a congenial road. There will be a change of personnel, and economics will become a |softer' subject than it now is. That may, indeed surely will, be desirable for all sorts of reasons. . ." (Hahn, 1991, p. 47).

Notes

(1.) These two sources of the mental models that individuals possess are termed "folk psychology" in the cognitive science literature. The term refers to the mundane, everyday understanding of ourselves and others. See A. Clark, Microcognition, Ch. 2. for a discussion of folk psychology. (2.) The transaction cost approach is unified only in its agreement on the importance of transaction costs. The approach development here might most appropriately be termed the University of Washington approach. Oliver Williamson has pioneered a somewhat different approach. (3.) Wallis and North, "Measuring the Transaction Sector in the American Economy, 1870-1970" in Engerman and Gallman, 1986 found that 45% of national income was devoted to transacting in 1970. (4.) See the author's "A Transaction Cost Theory of Politics", Journal of Theoretical Politics, Fall 1990.

References

Clark, Andy. Microcognition: Philosophy, Cognitive Science, and Parallel Distributed Processing. Cambridge: MIT Press, 1989. Coase, Ronald H. "The Nature of the Firm." Economica, Nov. 1973, 4, 386-405. _____. "The Problem of Social Cost." Journal of Law and Economics, Oct. 1960, 3, 1-44. Commons, John R. Legal Foundations of Capitalism. New York: MacMillan, 1924. Hahn, Frank H. "Information, Dynamics and Equilibrium." Scottish Journal of Political Economy, Nov. 1987, 34, 321-34. _____. "The Next Hundred Years." Economic Journal, Jan. 1991, 101, 47-50. North, Douglass C. "A Transaction Cost Theory of Politics." Journal of Theoretical Politics, Fall 1990, 2, 335-367. Simon, Herbert, A. "Rationality in Psychology and Economics" in Robin M. Hogarth and Melvin W. Reder (eds.), The Behavioral Foundations of Economic Theory. Chicago: University of Chicago Press, 1986. Wallis, John J. and North, Douglass C. "Measuring the Transaction Sector in the American Economy, 1870-1970" in Stanley L. Engerman and Robert E. Gallman (eds.), Long-Term Factors in American Economic Growth. Chicago: University of Chicago Press, 1986.