Understanding the Process of Economic Change

The Princeton Economic History of the Western World #32

by Douglass C. North

In this landmark work, a Nobel Prize-winning economist develops a new way of understanding the process by which economies change. Douglass North inspired a revolution in economic history a generation ago by demonstrating that economic performance is determined largely by the kind and quality of institutions that support markets. As he showed in two now classic books that inspired the New Institutional Economics (today a subfield of economics), property rights and transaction costs are fundamental determinants. Here, North explains how different societies arrive at the institutional infrastructure that greatly determines their economic trajectories.


North argues that economic change depends largely on "adaptive efficiency," a society's effectiveness in creating institutions that are productive, stable, fair, and broadly accepted--and, importantly, flexible enough to be changed or replaced in response to political and economic feedback. While adhering to his earlier definition of institutions as the formal and informal rules that constrain human economic behavior, he extends his analysis to explore the deeper determinants of how these rules evolve and how economies change. Drawing on recent work by psychologists, he identifies intentionality as the crucial variable and proceeds to demonstrate how intentionality emerges as the product of social learning and how it then shapes the economy's institutional foundations and thus its capacity to adapt to changing circumstances.



Understanding the Process of Economic Change accounts not only for past institutional change but also for the diverse performance of present-day economies. This major work is therefore also an essential guide to improving the performance of developing countries.

Genres: Economics, History, Nonfiction, Sociology, Law

200 pages, Paperback

First published August 19, 1998

About the author

Douglass Cecil North (November 5, 1920 – November 23, 2015) was an American economist known for his work in economic history. He was the co-recipient (with Robert William Fogel) of the 1993 Nobel Memorial Prize in Economic Sciences. In the words of the Nobel Committee, North and Fogel "renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change."

Reviews

[Erika RS · Rating 1 out of 5]

I considered giving this book an additional star because it was historically influential and contained some really interesting ideas. However, it was too badly written. There was not a clear argument. What was there was badly structured. The sentence structure was unnecessarily complex. The book was dense and used jargony terms without defining them. At the same time it was vague, making the same statement over and over again without fleshing out what was being claimed.

The ideas themselves, as far as I could extract them, were interesting. According to Wikipedia, the new institutional economics "is an economic perspective that attempts to extend economics by focusing on the institutions (that is to say the social and legal norms and rules) that underlie economic activity and with analysis beyond earlier institutional economics and neoclassical economics."

The key idea of this book is the world is more complex than individuals can handle. Therefore institutions (norms and rules, as opposed to organizations) evolve or are created to encapsulate human learning. However, they cannot be created arbitrarily. The bounded rationality of people plus the particular historical path that influenced a society's cultural learning means that the institutions of norms and rules are tightly tied to the society they came from. This makes it hard to translate ideas from one culture to another, as is illustrated by failed attempts to bring US-style constitutions to other countries without large investments to translate the necessary cultural norms. (Aside: We don't even know fully which norms are necessary!)

So there is something here. However, there are better ways to learn the same ideas. Complexity economics, as described in The Origin of Wealth covers many of the ideas about structural change and path dependency. Mark Granovetter's Society and Economy discusses the importance of norms and rules for how humans navigate through the world. And the field of behavioral economics, which was popularized in the twenty aughts, emphasizes that humans act under bounded rationality.

This book is commonly cited in works like those above, which is how I came to it. It was clearly an influential addition to the field at the time. However, I do not consider it a fundamental read at this point. Read the things that cite it, not the original.

I don't usually include my full detailed notes on Goodreads since I prefer people to read the original. In this case, I'll make an exception and include my detailed notes for the first 6 chapters.


Preface
The preface sets out that this book will explore the idea of how economies change. Although economic change is a dynamic evolutionary like process, it differs from biological evolution in that it is driven by human intention. This human intention is largely embedded in institutions and culture. This book will explore how that process happens. This human intention is largely embedded in institutions and culture. This book will explore how that process happens.

Chapter 1
This chapter lays out some of the key questions that the book will set out to answer. How do humans understand the world? How do they learn about it? How do they deal with the uncertainty? Part of the answer, we will see, is institutions, both formal and informal. Thus, how these institutions arise and cause change is another key question to explore. Part one lays out an analytical framework discussing these issues. Part two will lay out a historical exploration that utilizes that framework.

Part 1 introduction
Humans work to explain their environment and the institutions that they create to shape the environment. These institutions could be political, economic comment and social. Although these institutions are divided as fields of academic study, to understand the process of economic change we have to look at all of them together. Part one of understanding the process of economic change develops and expands on explorations of these different institutions to provide a framework for exploring the nature of economic change.

Chapter 2
Part I: This chapter discusses uncertainty and its role in economic progress. Humanity has worked to contain uncertainty over time and turn it into risk which can be estimated and balanced. Uncertainty has decreased over time from a variety of factors including increased in knowledge, and changing institutional structures. Yet there's also true novelty and residual uncertainty which remains even after novelty has been resolved. At these fringes previous human knowledge is not useful for predicting how to deal with the uncertainty.

Part II: Discusses non-ergodicity. Uncertainty and how we deal with it in the world are path dependent. Because the landscape of knowledge and institutions is always changing then there's no such thing as a complete reduction of uncertainty. New, fundamentally different uncertainties may always arrive. Thus even if agents have perfect perception their knowledge is only relevant in the moment; over time their knowledge becomes less valuable. Thus even institutions that are optimal at a given moment in time may be followed from the optimal as the human environment changes over time.

Chapter 3
"How humans perceive the human landscape, how they learn, and what they learn is the subject of this chapter." Another way to put what this chapter covers is the "relationship of the mind to the environment".

Part I: Establish that human cognition leads to human learning which leads to human institutions.

Part II: Establishes the idea that cognition is driven primarily by pattern matching. Humans do not reason rationally in the way that is commonly assumed by economists. Rather they look for patterns even finding them when they are not there.

Part III: Although the balance between genetic predisposition and cultural influence on human nature and human culture is as of yet unknown, what we do know is that both play a role. Evolutionary psychologists have established that much of human psychology is built on building blocks that have been determined by our evolutionary heritage. However, the influence of those blocks is loose and subject to cultural and contextual modification in their expression.

Part IV: Explores the idea of the connectionist model -- essentially neural networks -- as a way of representing human cognition. The key aspect of this particular model is that it allows humans to learn patterns and generalize and abstract them which appears to be consistent with how humans operate in the world.

Part V: Presents yet another view of the connectivist idea of how cognition works and then starts to connect this to human culture. Essentially, culture acts as the repository of artifacts of connections that have been discovered. By creating such a repository of artifacts, humans can reduce uncertainty to certainty or risk. This allows them even further reaching into new realms of uncertainty.

Chapter 4
Part I: Discusses the idea of consciousness. Consciousness is relevant to understanding economic change because the higher consciousness of humans is what leads us to have an awareness of the boundaries of our understanding. We are always pushing at these boundaries, and as part of this push we develop institutions which embody certain answers to the questions on these frontiers. Institutions help to establish order and conformity which reduce uncertainty and maintain order. However, the same institutional conformity prevents change, and punishes those who do not conform. However, in a world of uncertainty and perfect knowledge, change is critical. Thus it is important to have a diversity of institutions to allow for the flexibility that individual institutions do not have.

Part II: Starts to explain why different cultures have evolved in different ways and have shown different abilities to apply knowledge to solve economic problems. Part of the challenge, according to this section, is that human institutions are dealing with the change from problems of uncertainty in the physical environment to uncertainty in the human environment.
The physical vs human environment thesis is never really fleshed out or justified.

Part III: Anthropological studies across the globe have shown that the rational actor model assumed by economics is false across the world.

I'm still having trouble trying to figure out what the core point of this chapter is. What I think that it might be is that human cultures and human institutions arise from human consciousness and human nature which arise from our genetic heritage. Thus while culture is not determined by genetics, there is a connection between the two that we can trace. But I'm not sure that's the point it's trying to make. (As noted in chapter 5, part III, chapter 4 was trying to note is that cognition in a cultural context is what determines the belief that humans possess.)

Chapter 5
Explores cultural context as the scaffolding that shapes human interaction.

Part I: Establishes the idea that beliefs systems embody the internal representation of how humans interact with the world. Institutions are the structure that humans impose on the landscape to realize those belief structures. The structures in a system will reflect the belief systems of those who are in power (although being able to create institutions does not mean they will necessarily have the intended effects).

This section also differentiates between formal and informal institutions. Informal institutions include norms, conventions, and internally held codes of conduct. Formal institutions can be changed by fiat, but informal institutions are much harder to change and evolve in ways we still don't completely understand.

Part II: Culture is how norms, values, and ideas pass between generations. In particular it is how learning is passed down between generations. But how does that transfer happen? The first thing to realize is that the intergenerational transfer of knowledge is path dependent. Institutions are constrained by their past and these constraints impose limits on future changes. This is because institutions give rise to organizations which will do what they can to prevent alterations that threaten their survival.

Part III: Establishes the importance of transaction costs in the efficiency of economic organizations. Uses the example of the inefficiencies of politics to note that some transactions have high cost that are not going to be handled by the general market. Thus, in a very real sense, the government is meant to handle the things that the market cannot efficiently handle. But where do these different governmental institutions come from? They show such a wide variety over the world that saying that they are the margins of efficiency is not sufficient. We do not know in detail, but it does seem that demographic norms over time lead to different economic structures, such as in the contrast between African and Asian economic exchanges which seems to drive from their different densities of population and land use patterns.

Part IV: The section outlines, at 3 unnecessarily redundant levels of detail, five propositions about how institutions change.

Institutions, the rules of the game, interact with organizations. Organizations are the ways people come together to meet goals. The interactions between institutions and organizations are competitive which leads to institutional change. Because of this competition, organizations need to invest in skills and knowledge which allow them to have different choices and opportunities. These choices and opportunity modify the institutions over time. The institutional framework provides the incentives in which determine which types of skills and knowledge are invested in. However, this is mediated by the mental constructs of the organizations and the people in them. Because of all this institutional change is incremental and path dependent.

Chapter 6
Part I: Governments may be less efficient than markets because governments are left to solve the type of problems that markets cannot solve efficiently. However, that does not mean that governments are perfectly efficient at solving such problems. One challenge with governments, as opposed to markets, is that the incentive structure is less easily mapped to desired and optimal outcomes. For markets, the incentive structure is price, and insofar as price is the proper incentive structure for the transaction at hand, the market will work towards optimizing price.

However, when the optimal outcome has a more complicated fitness function, institutional incentives may or may not actually fulfill create the right incentive structure. This is because, in the thinking of The Origin of Wealth, there are longer and less clearly observable feedback loops at play. Thus, the incentive structure of organizations such as governments can tend towards self-interest of the actors involved in the government rather than the higher level goals that the organization was meant to achieve.

Part II: Economic development depends on the belief structures that have evolved the society, which in turn depend on the learning in that society. Learning is what enables societies to confront novel problems. However, it's not just the knowledge alone but also the artifactual structures that embody that culture and learning. In general, the richer the artifactual structure the more likely a society is to be able to confront novel problems successfully.

Part III: To understand how institutional behavior arises from human behavior we need to understand how human nature behaves. We know that the rational actor model of classical economics is decidedly wrong. However, we are still figuring out the right model. Anthropological investigation of past societies and how they transitioned from personal to impersonal exchange could help give insight

At this point, I decided that this book was too unorganized to take further detailed notes for.

[Richard Marney · Rating 5 out of 5]

This seminal work on the role of institutions in economic development propelled Dr. North to the Nobel Prize. In simple terms, “Institutions” (differentiated from organizations) are the rules, both formal and informal, by which society plays.

Their quality (including, dependability) is positively correlated to economic and political stability / performance, and hence social welfare and human development. Their resilience to exogenous shocks and capacity to manage destabilizing endogenous dynamics contribute to long-term sustainability.

A must read for students of economic development.

[Martin Lábaj · Rating 3 out of 5]

An extraordinary attempt to explain the role of institutions in the proces of economic development. Unlike many textbook-baby-version treatments of institutions, North provides a deep analysis of the human situation in the world and explains the roots of our institutions, their role in shaping our choices and behavior, and the process of their change. He explains how institutions provide an order in response to a chaos that emerges from unknown and uncertain world we live in. In this respect, his analysis of the social institutions is very close to basic human situation recently popularized by J. Peterson in 12 Rules for Life: An Antidote to Chaos and Beyond Order: 12 More Rules For Life. Our beliefs about the world create rules, norms, and responses to everyday situations in which we find ourselves. As thay may or may not correspond to a reality, we adapt our rules and institutions and create ever more complex artifactual structures. Succesful societies adapt their institutions as problems evolve. But there exist a never ending struggle between rigid institutions with proper responses to our problems that provide stability and attemts to replace them with new rules to respond to new challenges but open up a window for a disorder and disorganisation of the society. Overall, this book goes far beyond the scope of economics that deals with the problem of resource allocations and heads towards a more fundamental problems of the humankind. The framework that goes from beliefs to institutions, organizatins, policies and outcomes is applied to explain our pre-historic origins, industrial era, political/economic tranformation in England, the rise and fall of Russia, and many other regions and epochs. Eventhough there has been inarguably big progress made in economics and other social sciences since North´s research (e.g. The Narrow Corridor: States, Societies, and the Fate of Liberty) treatment of the interplay between the power of the society and power of the state in shaping the societal development) the book is definitely worth reading as it provides many insights that are - to exacerbate a bit - at the margin or overlooked in our economics profession.

[Lance Cahill · Rating 4 out of 5]

Fascinating overview of North’s focus on the process of economic change in society, with a focus on institutions and how institutions shape and are shaped by existing norms, highlighting difficulty of crafting economic institutions on societies without the requisite experience, highlighting difficulties of market reform in Latin and South America and the Soviet Union.

First few chapters feel only loosely related to the rest of the book and are a digression, in my view, on consciousness and intentionality. North ties this into his overall theory of why institutions are successful (adaptive efficiency), but ultimately feels out of place.

Good contribution to discussion of whether ‘markets’ arrive through a spontaneous order or conscious design. North views institutions as gradually developing to minimize transaction costs if allowed by political actors. For instance, protection of private property was a concession granted in interest of the sovereign collecting revenue that ultimately enhanced and extended impersonal exchange.

Bit of a mid way between Hayek’s (simplified version) of a spontaneous and the Rosseau/Heilbroner view that economic society is artificial and economic organization has no independent meaning.

[Thy Duong · Rating 2 out of 5]

For some moments, I forgot this book was initially written by an economist. For other moments, he attempted to write about economics from cognitive science, which I felt like he repeated himself many times without explicit conclusions. The role of institutions is discussed but I also feel like it is again just the same as Coase, quite theoretical.

Summing up, this book could have been more succinct.

[Fernando Saldanha · Rating 2 out of 5]

Too vague, dispersed

I purchased this book with great hopes, but was sorely disappointed. It is not that I disagree with the author's ideas, but rather that the book seems to lack a central thesis. Reasonable and/or more or less obvious statements are endlessly lined up. At the end of the book one feels like asking "So what? "

[Dio Mavroyannis · Rating 3 out of 5]

Too much of a summary, glosses over too many important ideas.

[A Ter · Rating 2 out of 5]

dated

[Liberté · Rating 5 out of 5]

This book is a dense but important read. North is one of the foundational scholars of institutional economics, and this book is a good introduction to the concepts which underlie new institutional economics theory and a framework for understanding the system of thought. It also provides useful references for future reading, and stimulates plenty of new ideas of your own. Be aware there are sentences longer than some paragraphs in this book, and that it does require careful reading and analysis.

[Tobias · Rating 4 out of 5]

Challenging and even a little frustrating in its inconclusiveness, this is nevertheless a great synthesis of the New Institutionalism that tries to establish micro foundations for institutional change - sort of the holy grail for Institutionalism - by looking to neuroscience and psychology. Points in an interesting direction, but ultimately North admits that we don't really know for certain by certain institutions beneficial for growth take root in some places but not others.

[Hamilton Carvalho · Rating 5 out of 5]

Concise, but insightful book. Ideas from psychology, evolution and shared mental models. Humble about the state of our knowledge. Overall, a great book.