Institutions (1991)
Douglass North's 1991 paper summarizes much of his earlier work relating to economic and institutional change. In this paper, North defines institutions as “humanly devised constraints that structure political, economic and social interactions.” Constraints, as North describes, are devised as formal rules (constitutions, laws, property rights) and informal restraints (sanctions, taboos, customs, traditions, code of conduct), which usually contribute to the perpetuation of order and safety within a market or society. The degree to which they are effective is subject to varying circumstances, such as a government's limited coercive force, a lack of organized state, or the presence of strong religious precept.
Section 2 describes the economic development of societies as occurring in stages:
He begins with local exchange within the village. In this setting, specialization “is rudimentary and self-sufficiency characterizes most individual households”, with small-scale village trade existing within dense social networks of informal constraints that facilitate local exchange, and a relatively low transaction cost. In this close-knit network “people have an intimate understanding of each other, and the threat of violence is a continuous force for preserving order…”
With growth the market extends beyond the village into larger, interconnected regions. As the participants of a transaction become more socially distant the terms of exchange must be made more explicit. This increase in transaction costs necessitates institutions that reduce the risks of being cheated, either by raising "the benefits of cooperative solutions or the costs of defection."
As long-distance trade becomes more feasible, generally through caravans or lengthy ship voyages, individuals and groups experience occupational and geographic specialization. Society also experiences a rise of formal trading centers (temporary gathering places, towns or cities). From the development of long-distance trade arise two transactional cost problems: Agency: the transfer of one's goods or services outside the control of local rule leaves the rules of exchange undefined, the risk of unfair trade high, and the contracts within society unenforced. For this reason merchants often would send their kin or a sedentary merchant with the product to ensure its safe arrival, and the fulfillment of agreed terms of exchange by the receiving party. Contract: covered briefly in “agency” above, problems with negotiation of contracts and enforcement of contract stipulation. Historically this problem was met with either armed forces protecting ships or caravans, or use of tolls by local coercive groups. However, in modern societies, institutions acting cooperatively in the interest of free market trade provide protection for goods and enforcement of contracts. Negotiation and enforcement in alien parts of the world require the development of a standardized system of weights and measures.
As development continues, the rise of capital markets (protection of property rights), creates social capital and enables citizens to gain wealth. Technology plays an instrumental role in the continued development of manufacturing sectors, and acts to lower transaction costs in several ways. The most substantial benefits are generally the result of transportation improvements.
Eventually, society becomes overwhelmingly urban. This final stage of development specialization requires increasing percentages of the resources of the society to be active in the market so that the transaction sector becomes a large share of gross national product. Highly specialized forms of transaction organizations emerge at this stage. Globalized specialization and division of labor demand institutions to ensure property rights even when trading in neighboring countries enabling capital markets to develop “with credible commitment on the part of the players.”
3 primitive types of exchange: Tribal Society- “relies on a dense social network.” Colson (1974, p. 59) Bazaars- “high measurement costs; continuous effort at clientization; intensive bargaining at every margin.” Long-distance caravan trade- illustrates the informal constraints that made trade possible in a world where protection was essential and no organized state existed. All three methods above are found to be much less likely to evolve.
North's paper concludes with a few intriguing questions which his paper has aimed to address: What is it about informal constraints that give them such a pervasive influence upon the long-run character of economies? What is the relationship between formal and informal constraints? How does an economy develop the informal constraints that make individuals constrain their behavior so that they make political and judicial systems effective forces for third party enforcement?
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