Book Review by the One Handed Economist

“Institutions, Institutional Change and Economic Performance”

– by Douglass C. North

The one-handed economist

Douglass North develops an analytical framework for explaining the ways in which institutions and institutional change affect the performance of economies, both at a given time and over time. Institutions exist, he argues, due to the uncertainties involved in human interaction; they are the constraints devised to structure that interaction.

Douglass North’s 1990 book, Institutions, Institutional Change and Economic Performance, is required reading in the introductory course for our Governance, Economics and Development major.

Although I have read some of North’s other works, I only now have read this one. I am glad that I did but a little sad that I only “got to it” now.

That’s because this slim book (150pp) does a great job at explaining what institutions are, why they matter, and how they change. How can North do this? Decades of experience and thinking about the topic.

Let’s go over some highlights.

1. Most neo-classical economics (the kind that most people are taught) ignore institutions (“the rules of the game”) by assuming that they work flawlessly or don’t matter. Such a view is naive in a real world where there are (transactions) costs to making and enforcing deals, where everyone tries to change the rules to benefit themselves, where people are desperate to migrate to different institutional settings, and so on.
2. Institutions change quickly (pick-up basketball) or slowly (Buddhism), as they influence (and are influenced by) the costs and benefits of our choices.
3. Here’s a thought exercise for the classroom:
   1. Two students from different countries (or groups) spin the wheel.
   2. The wheel has many elements of life (religion, foods, job mix, weather, etc.) and the wheel stops on one of them.
   3. The two students then “switch” that element between their countries, e.g., a French student and a German student swap “institutions of lunch” or “institutions of greetings.” What happens next? How does that change people’s interactions? How does it spill over to other institutions? How has that element evolved over time?
   4. Discuss.
4. “Organizations” are groups of people, united around a goal. People often call these “institutions,” e.g., “Harvard is an institution of higher learning,” but it’s better to keep these words apart — as we should with “risk” vs “uncertainty.” So Harvard is an organization, and it has institutions (funny names and all that), but those institutions change in different, bottom-up and top-down ways in comparison to “the organization.”
5. “Institutions alter prices… and thus ideas, ideologies and dogmas.. playing a major role in the choices individuals make” (p22).
6. There’s a tension between formal rules and informal constraints — two elements defining “the rules of the game.” Think about gay marriage, cannabis legalization, fair play, etc.
7. Those who make rules often seek their self-interest. Those rules may be neither fair, nor efficient. Rules on race, migration, access to education or medical care, and so on.
8. The smaller the transaction costs of making and enforcing a deal, the closer is market efficiency to the neoclassical, “frictionless” standard.
9. North offers a “two-year wait” for a telephone as an example of a transaction cost. The book was published in 1990, so it was probably written before the Berlin Wall fell. In command economies, one of the biggest problems (in terms of quality of life) was high transaction costs, but the same is/was true with monopolies in market economies. I remember how MCI disrupted AT&T’s long-distance (LD) monopoly in the 1980s and 1990s. The cost of LD calls dropped radically (here’s a discussion). The arrival of mobile phones, with their radically cheaper fixed network infrastructure, and VOIP, which can use the internet as a LD backbone, dropper prices even further. Today we make free video calls around the world as if that’s perfectly normal!
10. The agent of change, the entrepreneur, alters relative prices. This process is usually incremental — so en garde, citoyens! The French Revolution began in 1789. Louis XVI was guillotined in 1793. In 1799, Napoleon and two others ruled in a triumvirate, and he crowned himself emperor in 1804. So that was around a decade without an absolute monarch, and it wasn’t until 1870 (the Third French Republic) that the country was firmly on the “liberté, egalité, fraternité” path.
11. Path dependence is a real problem when it “locks in” an inefficient system (e.g., weights and measures in the US). Change is difficult because of the higher transactions costs of coordinating diffuse players with varying preferences (radical, conservative, indifferent). A player can bring change by paying all costs themself and then sharing the benefits with others (a subsidy to the public good, as I discuss in my book on the commons), which is more frequent than economic theory (homo economicus) would predict but less frequent than we need (e.g., sustainability transition or ending poverty).
12. Efficiency in political markets is hard to achieve without universal sufferage, simple (one-item) laws, and strong feedback from voters to representatives. Democracy is better than autocracy, just as direct democracy is better than representative democracy, but both (improvements) require real commitment from voter/citizens.
13. The lack of participation among voters in many democracies is not necessarily a clear sign of indifference. It’s often a sign of giving into path dependency, a feeling that many politicians encourage to retain power. (The expression “après moi, le déluge” seems to fit here, but its meaning and use has evolved since Louis XV said it in 1757.)
14. Economical and political models are built on a mass of institutions, which makes it hard to transplant systems among countries. This “obvious” point wasn’t obvious enough when so many former-communist countries failed convert to market democracies. They are getting closer now, but that process (as North would have predicted) is taking decades. (The same can be said of South American “democracies” that adopted variations of the US constitution around 200 years ago!)
15. “Marxist theory is deficient…” [remember, this book was written around when the Berlin Wall fell and the CPC ordered the Tiananmen massacre] “…because it entails a fundamental change in human behavior… technological change [a là capitalism] as the key to utopia is likewise deficient…” The key to human flourishing is cooperation (pp 132-3).

I strongly recommend this book to anyone interested in the social sciences (especially economists!) and anyone devoted to human flourishing. FIVE STARS.