The year I was born, Douglass North published a paper [pdf] in the Journal of Economic Perspectives, titled “Institutions”.
Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights). Throughout history, institutions have been devised by human beings to create order and reduce uncertainty in exchange. Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity. They evolve incrementally, connecting the past with the present and the future; history in consequence is largely a story of institutional evolution in which the historical performance of economies can only be understood as a part of a sequential story. Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline.
Douglass demarcates Institutions from the more tribal, specific, directed units called Organizations. In practice, I don’t know that these two ideas are easily separable.
Institutions provide clear utility for two reasons:
- If there are many people involved, and if there is no social cohesion, and if transactions are not repeated, cooperation is difficult and unreliable to achieve. Institutions can have memories and can reliably provide impersonal revenge against defectors (“Justice”)
- Managing transaction costs: Institutions can act as mediators, addressing property rights problems and explicit terms of trade, including matters of measure (weight, size, currency).
Douglass identifies three simple kinds of economic exchange:
- Tribal: intra-village tribal exchange, which depends on social cohesion and closeness. Most households are self-sufficient, so trade was light and people knew each other well (or were able to physically punish wrongdoers), and transaction costs were low. Specialization was unnecessary because everyone was a generalist on the matter of
- Bazaar: As regions connect by growing markets, agents are more ‘socially distant’ and so there must be more explicit rules on the terms of trade. Transactions costs are higher, and institutions are useful to help mitigate risks (by punishing cheaters or rewarding good participation).
- Caravan: Physical and social distance. Specialization becomes more important. Wikipedia:
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.
Alongside Ronald Coase and others, Douglass North is identified as a “New Institutional Economist”.
Another dichotomy I discovered recently: Saltwater vs Freshwater economics. That is, the Keynesian angle preferred by the “coastal” elite schools, versus the various alternative visions birthed in the schools closer to the Great Lakes region (including a subset once known as the Carnegie School at my alma mater [mostly integrated into other schools at this point], and the more prominent Chicago School at my brother’s).