Institutions, Institutional Changes, and economic performance (Douglass North 1991)

1.  There are transactional costs that prevents the maximizing of utility between an economic change.
2.  Institutions help in reducing the transactional costs.
3.  Institutions produce lock-in, which makes institutional change difficult, 
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7. My brother in law has given me a book about Libertarianism to read, so I thought I'd read something mainstream first. A book that discusses institutions, what they're meant to do, how they influence the economy and how they can improve.
   
   I got lucky. This book by Douglass North is an excellent primer. In 14 short chapters (some 10 pages each) it covers a thousand pages' worth of ground, no exaggeration. Each chapter starts with an abstract. You could read the 14 abstracts (comfortably less than 20 pages, all told) and get the idea. After the abstract the author gives the main points of the chapter, with zero repetition. Within the text, rather than at the end, he lists several sources for further reading.
   
   On the flip side, this ain't bedside reading. It's the bare bones of a textbook, written for people in academia. You cannot even dream of skimming it. It feels like 14 dense lectures, really.
   
   Here are ten points I took away:
   
   1. In a world of infinite choices, institutions are defined as a set of restrictions imposed on our freedom with the main aim of increasing efficiency. In every society there's one way to get married, one way to bury the dead, one way to sell a house, one way to participate in politics, one way to appeal to justice etc. These days there could be a couple ways, but you get the idea. So if you go to a foreign land you would not know where to start with the basics, you'd need a local to show you the institutions.
   
   2. Efficiency creeps into the narrative as follows: In a repeated game, people will behave. In one-off games, however, (example: a one-off round of prisoner's dilemma, or the one time in your life when you might sell your house), the incentives are skewed toward selfish behavior. Similarly, if you are dealing with a stranger, you are significantly less likely to behave than if it's with somebody you know. This means that it could be costly to transact: The guy on the wrong side of the information asymmetry will compensate for the cost of gathering information and for the risk of doing a bad deal by adding back his costs to arrive at the price where he's happy to transact. Institutions are meant to reduce these costs.
   
   3. This takes precedence over maximisation of welfare / wealth. Indeed, institutions can entrench inefficient local maxima. Moreover, institutions that are good for economic growth don't necessarily have an advantage over institutions that are bad for growth in terms of being sticky / persistent. Change happens at the margins.
   
   4. Some institutions / rules are formal, like laws. Some are informal and unwritten, like customs. The former are easier to change with the stroke of a pen. The latter die hard. That said, the difference between formal and informal constraints is one of degree. In practice, there is a continuum between the formal and the informal. There is a distinct hierarchy in formal rules, for example. The Constitution is a bigger deal than a specific law, which is in turn a bigger deal than some local bylaw, which could incidentally be less enforceable than some old tradition.
   
   5. It's chiefly political rules (also known as property rights) that influence economic rules, but change in economic rules can also eventually lead to changes in property rights / politics. Political rules, moreover, get more complicated as the sundry constituencies and interest groups become more varied and diverse.
   
   6. The role of government is to enforce contracts. This, in turn causes a principal-agent problem. The people in government (be it legislation, justice or enforcement) will act rationally and do what's best for them, not those who elected them. The author does not claim to have the answer to this major problem! But a main thesis of the book is that in the rich countries of the world we've somehow got this balance right, at least when you compare us with the third world.
   
   7. Since we all know what's going on everywhere else in the world these days, it does not take much to find out what institutions perform better. Regardless, we don't see the backward places adopting the institutions of the more advanced places. That's because there are costs in changing institutions. And if these "political transaction costs" are very high, inefficient property rights (also known as political institutions for the purposes of this book) can persist for a very long time.
   
   8. Change in institutions (as well as resistance to change) often comes under pressure from organizations such as guilds, firms, unions etc. rather than individuals. These organizations accumulate knowledge and know-how that put them in a position to exert pressure on the polity to change the explicit rules, if not the informal ones such as customs and traditions. This they do mainly by changing relative prices, but not only. An institution that was not abolished via changes in relative prices, for example, was slavery. Typically, however, an organization succeeds in providing a service or making a product at a more competitive price (or enforces a higher price) and this leads both sides of a bargain to accept changes in the contracts that are nested in the hierarchy of norms, behaviours and rules.
   
   9. Changes in informal institutions are more complex. They require changes in culture.
   
   10. Not all changes in institutions are gradual. Lack of compromise (for example war or revolution) can often bring about sudden change in institutions. However, the issues over which compromise was not reached and eventually led to the lack of compromise ,will more often than not have festered for some time. Technological change can also result in sudden change of institutions.
   
   Having made these points (and many more) in the first 100-odd pages of the book, the author goes on to make a rather major claim: Institutions are the underlying determinant of long-run performance of economies.
   
   If we accept this to be true, then we need to reconsider the current (neoclassical) theory and do our best to embed what we know about institutions, with a large number of implications. It would introduce, for example, path dependence to our understanding of economies since we have established that institutions are sticky.
   
   The evolution of modern finance also gets a very strong billing in the closing part of the book, which takes us through a bunch of stages we had to go through, each one involving a formal or informal organization introducing a financial innovation that reduced risk and eventually became an institution. It apparently all started with ways we had to devise to go around usury laws, and today it has culminated in insurance contracts which convert "uncertainty" into measurable "risk" that can be distributed. I was wondering out loud what Douglass North would make of today's derivatives world. This chapter could have been written by Greenspan himself (both for its content, but also unfortunately for its sometimes convoluted language)
   
   In the closing chapter, Douglass North pats himself on the back for having rejected the neoclassical (and the Marxist) models for growth, but admits there is work to be done in using the tools he has introduced to point the way forward. The two obstacles he sees to growth should not come as a surprise to his readers: (i) the difficulty in overcoming inefficient informal institutions (also known as culture) and (ii) the impossibility of bearing the large political costs that will be necessary to move away from inefficient solutions.
   
   So if you are looking for a way to unseat the 28 "closed professions" in Italy or the innumerable princelings and party insiders who lord it over China, all he's got to tell you is "good luck." Still, I loved reading the book. So I'll overlook the dense and often inscrutable writing style and award it a full score.
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10. Douglass North’s Nobel prize-winning research identifies heuristic deficiencies which have persisted in economics. He demonstrates how certain enduring neo-classical assumptions imbedded within hypotheses are flawed. These inadequate assumptions are in turn contributing towards an imperfect understanding of the factors shaping economic growth. Institutions need to occupy a central position if the discipline is to remedy its analytical paucity and discover what accounts for divergent and disparate economic performance.
    
    What are these institutions North advocates as a methodical foundation? He defines institutions simply as ‘the framework, the rules, which define how the game is played’. Institutions also share similar characteristics: they are fundamentally created, evolve and are altered by humans; there is a symbiotic relationship between organisations (firms, labour unions, constituents, etc.) and institutions; institutions evolved as a result of incentive structures; they can be either formal (rules devised) or informal (conventions and codes of behaviour); and they exist to reduce uncertainties in human interaction.
    
    North goes on to dismantle entrenched neo-classical assumptions which he believes are deficient. His first target is rational choice theory. He correctly identifies extant problems in behavioural theories and information processing capacity. Neo-classical economics uses the rational actor as the basis for its models, and this theory makes three fundamentally incorrect assertions which are not observable in practice. Firstly, it assumes the actor possess complete information; secondly, agents are exclusively defined by wealth-maximising behaviour; and thirdly, the environment is deciphered through tabula rasa-type mental construct which is objectively shared by all agents. What is fundamentally missing is an ‘understanding of the nature of human coordination and cooperation’. A behavioural model is therefore needed.
    
    North found the research undertaken in Game Theory was an effective way to observe cooperation among economic actors. The precepts put forth are that wealth-maximising individuals will usually find it worthwhile to cooperate with others when the play is repeated, when they possess complete information about player’s past performances, and when there are a small number of players. North’s ground-breaking concept which transformed economics’ examination of agents’ cooperative behaviour drew inspiration from Ronald Coase’s 1937 publication ‘The Nature of the Firm’. Coase’s assertion is that when it is costly to transact, institutions matter – transaction costs are the basis for a firm’s existence. North incorporated transaction costs into his institutional model to create a new basis for understanding economic exchange and development.
    
    In North’s model he begins with a basic assertion: incomplete information leads to increased costs. The costliness of information is key in the cost of transacting. What North means by the cost of information is the resources that are needed to measure the attributes lumped into a good or service. There are two costs that are associated with exchange between parties, the cost of measuring the valuable attributes of what is being exchanged, and the cost of protecting rights and enforcing agreements. Therefore, total cost of production equals land, labour, capital and transacting. Given the prevalence of incomplete information, institutions are needed to structure interactions. Measuring transaction costs is the best way to measure the effectiveness of institutions.
    
    Measuring transaction costs is also a reliable way to evaluate economic development. An undeveloped economy is characterised by low transaction costs (small-scale production, cultural homogeneity, local trade), and high transformation costs (rudimentary specialisation and division of labour). As an economy develops, increases in size and scope of transactions lead to impersonal exchange. Third-Party enforcement is the critical underpinning of successful modern economies.
    
    Not content with incorporating transaction costs into his theory, North also wants to demonstrate the imperative of considering what he calls ‘informal constraints’, in other words, culture. North claims that informal constraints play an important role in altering institutions and are more resistant to change than formal constraints (formal rules, laws, etc.) due to their ability to resolve basic exchange problems. Culture and its transmission is an important determinant of economic development trajectories.
    
    A simplified way North suggests one can understand an economy is that institutions are the entities that provide the rules of the game and organisations are the players. He describes organisations in his model as ‘purposive entities designed by their creators to maximise wealth, income, or other objectives defined by the opportunities afforded by the institutional structure of society.’
    
    Along with broader informal constraints, organisations also seek to affect change. How they interact with institutions and other functional constraints (technology, income, preferences) influences institutional change. These are self-interested agents that will devote resources to altering institutions at the margins relative to their respective bargaining power. Organisations are self-interested, perpetuating, and in aggregate determine priorities in economic growth. Having in place resilient though advantageously flexible institutions which cannot be captured by narrowly-interested agents is therefore paramount. They must also provide incentives for catalysing productive economic activity.
    
    Concluding, North provides empirical evidence for his assertions. He examines the divergent paths of the Spanish and British empires, and gives an overview of modern financial systems. He finds in these respective cases that the degree of institutions’ marginal adjustments differ between countries, as does the relative bargaining power of the participants to alter existing arrangements. ‘Preceding institutional arrangements’ also shape the extent to which adjustments can occur within an institutional structure. Therefore, institutional change does not occur to the same degree across differing systems, is shaped by different actors’ subjective choices, different histories, and incomplete feedback on the consequences. This explains why marginal adjustment does not lead to convergence.
    
    A crucial book for understanding the complexity of exchange, development economics, the importance of rule of law and property rights, and the interplay between politics and economics.
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18. Ronald Coase -