Douglass North on Institutions

The late economist Douglass North is one of the most underrated in the field. He won the Nobel Prize, but you’ll never hear his name or work discussed in a traditional economics class. It’s a shame, because the work he produced was foundational to creating a coherent framework of how societies, power structures, and economies evolve.

North was precocious and curious enough to triple major in political science, philosophy, and economics, yet not terribly concerned over something as cosmetic as a GPA — he graduated with a healthy C average from Berkeley. A clear bon vivant, he sailed the seas for three years as a deckhand and nearly became a photographer before ultimately opting to complete an economics PhD, a necessary step on the path to his eventual Nobel Prize. I like to imagine this wide aperture on life made North particularly able to pinpoint the paradoxes and puzzles that long went unexamined in economics.

The greatest frustration North had with the study of economics is best summarized in his own words. “The formal economic constraints or property rights are specified and enforced by political institutions, and the literature simply takes those as a given. But economic history is overwhelmingly a story of economies that failed to produce a set of economic rules of the game (with enforcement) that induce sustained economic growth.” North’s major contribution to economics was to uncover how the principles we took for granted came to be in the first place, how societies evolved from those where kings controlled all lands and subjects to ones where all individuals could inherit and protect what was theirs.

His work is powerful because it teaches the reader to recognize the world and its underlying structures as dynamic, untethering one from the naive belief that “things always return to normal.” North knew that normalcy could be lost, for better or worse.

The era we inhabit is one of institutional upheaval and in this era, it’s best to be armed with North’s wisdom to understand how we got here and where we are likely to go. Below is a summary and commentary on North’s essay, “Institutions.”

The Game Theory in Economic Interactions

A game theoretic framework is foundational in helping us understand how economies work and what behaviors can be expected from its participants. Okay — but what’s a game?

I pass the baton to Professor Gass at the University of Maryland to explain, “A game is the set of rules that describe it. An instance of the game from beginning to end is known as a play of the game.”

In tic-tac-toe, the rules are:

• You play on a grid of 3 x 3 squares
• Player 1 is X, Player 2 is O.
• Players take turns putting their marks in empty squares.
• The first player to get 3 marks in a row wins.
• If all nine squares are full and no player has managed a row-of-3, the game ends in a tie.

Professor Gass adds, “a pure strategy is an overall plan specifying moves to be taken in all eventualities that can arise in a play of the game. A game is said to have perfect information if, throughout its play, all the rules, possible choices, and past history of play by any player are known to all participants. Games like tic-tac-toe, backgammon and chess are games with perfect information and such games are solved by pure strategies. But whereas you may be able to describe all such pure strategies for tic-tac-toe, it is not possible to do so for chess, hence the latter’s age-old intrigue.”

Sequential games can be visually mapped out in trees like the one below, and we can use them to assess which strategies are most optimal for players. The rules of the game below are:

• Players take turns picking whether to go left or right.
• Player 1 goes first, followed by Player 2, and then Player 3.
• After Player 3’s turn, the game ends and each player receives their payoff.

By analyzing the payoff tree below, we can deduce what strategies players should take to end up with the highest payoff.

So for example, if we use backwards induction, we can determine the set of Player 3’s optimal strategies, which helps us determine the set of Player 2’s optimal strategies, which helps us determine Player 1’s optimal strategy — which is playing “Left” to end up at a final payout of (2,5,5). At this point, we have “solved” this game because we know that Player 1 will always go left.

Finding pure strategies in chess through backwards induction was what José Raul Capablanca was talking about when he said, “In order to improve your game, you must study the endgame before everything else. For whereas the endings can be studied and mastered by themselves, the middle game and opening must be studied in relation to the end game.”

By looking at this game tree, we can also see that changes to either the rules or payout structure of the game will influence the optimal strategies for the players in the game.

Institutions, North says, are just like the rules and incentive structures exhibited in these games. They are the rules that provide the incentive structure for our economy.

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). 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.

Why do we need rules for the economic game? Perhaps the best way to visualize this is to imagine a game of chess with no rules. If there’s no definition of what “winning” or “losing” looks like, it’s not clear why we would engage in the activity in the first place. Institutions don’t just help set the outcomes of the game, by doing so, they also help inform us about what we can expect from others playing the game alongside us. Without some set of rules we all agree on, trust and cooperation become impossible.

Games can also be broken down into either finite or infinite games. Finite games end in a finite number of moves whereas infinite games consist of a series of repeated interactions that go on ad infinitum. Game theory teaches us that under certain types of games, cooperation is more difficult to attain.

To illustrate this, let’s suppose we have a flour merchant, A, at a local market playing a finite game, and flour merchant, B, playing an infinite game. In both cases, the merchants’ objective are the same — to maximize profit. Since merchant A is playing a finite game, one way he can maximize his profits is by not selling flour at all, but rather bagging sand and selling it to unwitting buyers. Since he will never return to the market again, he can pocket the profits after one day of sales and end the game. In other words, the fact that merchant A is engaged in a finite game means it is easier for him to renege on his agreements with his buyers. In this finite game, lying is an optimal strategy.

This strategy, however, wouldn’t work for merchant B who must return to the market and sell flour every day ad infinitum. If he pulled such a stunt, he would soon lose all customers, because by the second day, no one would trust him. The element of repeated play makes it much more difficult for merchant B to renege on agreements with buyers, and the costs of reneging induce him to cooperate and make good on his promises with buyers. In this infinite game, lying is a sub-optimal strategy.

This is what North means when he says, wealth-maximizing individuals will usually find it worthwhile to cooperate with other players when the play is repeated, when they possess complete information about the other player’s past performance, and when there are small numbers of players. But turn the game upside down. Cooperation is difficult to sustain when the game is not repeated (or there is an endgame), when information on the other players is lacking, and when there are large numbers of players.

Whenever the ability to renege is high, cooperation becomes more difficult and the costs of transacting go up. When the costs of transacting exceed the profit from the interaction, economic activity stops. Institutions, therefore, are put in place to allow economic exchange to continue taking place. As North puts it, institutions and the effectiveness of enforcement (together with the technology employed) determine the cost of transacting. Effective institutions raise the benefits of cooperative solutions or the costs of defection, to use game theoretic terms.

Evolving Economies, Evolving Institutions

The economy is a game and we’re all players in it — but who gets to set the rules? North answers this excellent question in a book he wrote alongside John Wallis and Barry Weingast called Violence and Social Orders, A Conceptual Framework for Interpreting Recorded Human History. It’s an answer I’ll definitely treat in a future blog post, but to sum it up — those with the most power are the ones that set the rules. However, power shifts from group to group, from an individual to a collective and vice versa, as changes in circumstance, material wealth and technology benefit certain players over others.

Changes in power and resources create new circumstances. These circumstances lead to new incentive structures for players that changes the economic game they’re playing.

North doesn’t go into all that in this essay, but he does outline how the economic “game” has changed over time, and what institutions were required to be built as the game got more complex. I’ve interspersed quotes from the essay below, they’re italicized. I’ve bucketed the main stages of these changes as follows:

1. Autarky and small scale trade. Trade takes place in local markets. The main institutions governing exchange come from strict social customs that severely punish those who break agreements. Dense social networks ensure that trust is high. The threat of violence is a continuous force for preserving order. Costs of transacting are low.

2. Large-scale trade. Trade graduates to a regional market connecting multiple localities. Trade happens for the first time with strangers. The size of the market grows and transaction costs increase sharply because the dense social network is replaced; hence, more resources must be devoted to measurement and enforcement. Greater information asymmetry means parties need to ensure they’re really getting what they paid for. These quality checks make transacting more expensive. North writes, In the absence of a state that enforced contracts, religious precepts usually imposed standards of conduct on the players.

3. Long-distance trade. The growth of long distance trade poses two distinct transaction cost problems. One is a classical problem of agency, which historically was met by use of kin in long-distance trade. You wouldn’t trust a stranger to transport a shipment of goods to a distant land with limited communication. Otherwise, each day you’d be wondering if the ship would ever return, and if it did, would the profits ever be returned to you? Nepotism is an optimal strategy that arises to decrease the risks from the principal-agent problem. Here, meritocracy is a sub-optimal strategy. A second problem consisted of contract negotiation and enforcement in alien parts of the world, where there is no easily available way to achieve agreement and enforce contracts. Enforcement means not only such enforcement of agreements but also protection of the goods and services en route from pirates, brigands, and so on. More resources must be devoted to security, whether by hiring men to protect cargo, or by creating long-standing agreements with agents abroad who earn rents from agreeing to protect shipments in the future. The problems of enforcement en route were met by armed forces protecting the ship or caravan or by the payment of tolls or protection money to local coercive groups. Given that continuous trade overseas is a repeated game, defection from such agreements by “local coercive groups” would be a sub-optimal strategy, which increases the likelihood of their cooperation.

4. The demands of production outgrow the capacity of trustworthy labor. You don’t have enough kin to handle the production, packaging and shipment of goods. To grow marketshare, labor must be found elsewhere and must specialize. Micromanagement cannot scale. Economies of scale result in the beginnings of hierarchical producing organizations, with full-time workers working either in a central place or in a sequential production process. The principal-agent problem rears its head again. Such societies need effective, impersonal contract enforcement, because personal ties, voluntaristic constraints, and ostracism are no longer effective as more complex and impersonal forms of exchange emerge. To prevent hired labor from stealing, for instance, impersonal institutions, like courts must exist which will increase the costs of acting unfaithfully.

5. The demands of production outgrow the capacity of available capital. You’ve hired all the people you possibly can, and would hire more — but don’t have enough cash on hand to do it. Without credit, growth is impossible. To expand production, capital markets must emerge. Abstraction, in the form of non-tangible assets, enter the economic picture. Lenders may issue debt, but need strong assurances that it will be repaid. Here, lenders need assurances that even if institutions with the power to penalize delinquent borrowers exist — that these institutions will not rule against the lender arbitrarily, seize their assets, or act unjustly in any way. In other words, without secure property rights, capital markets cannot emerge. Establishing a credible commitment to secure property rights over time requires either a ruler who exercises forbearance and restraint in using coercive force, or the shackling of the ruler’s power to prevent arbitrary seizure of assets. He goes on to say, the first alternative was seldom successful for very long in the face of the ubiquitous fiscal crises of rulers (largely as a consequence of repeated warfare). The latter entailed a fundamental restructuring of the polity such as occurred in England as a result of the Glorious Revolution of 1688, which resulted in parliamentary supremacy over the crown. Absolute centralized rule may be effective and decisive, but isn’t very good for capital markets long-term. Governments, which are economic agents too and must borrow money, are also playing a long term game. Making it extremely costly for governments to seize property is one strategy to curtail the arbitrary use of power. Douglass North and Barry Weingast chronicled the emergence of property rights in England and documented how elites curtailed the power of the crown in “Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England.”

6. Growing economic complexity requires specialized management. As impersonal institutions like courts grow in authority, economies of scale and ever-greater specialization become possible. In this final stage, specialization requires increasing percentages of the resources of the society to be engaged in transacting, so that the transaction sector rises to be a large percentage of gross national product. If laboring households spend all their time involved in producing only one piece of the economic pie, they will need to transact to secure every additional good or service they require to live. As transactions themselves become impersonal and ubiquitous, institutions like the financial system and banks must arise to guarantee the transactions.

Technology vs. Institutions

As economies grow, institutions can help set the rules of exchange and lower the barriers to transacting. That doesn’t necessarily mean that institutions are durable over time, or even that effective! It’s very possible for institutions to solve one problem, while creating another. Often, institutions fail and new ones are needed to replace them. Other times, institutions become obsolete or so rigid that they begin to stand in the way of willing parties who want to transact.

The story of technology, which is not treated in-depth in North’s analysis here but which North gives us the tools to assess, is a crucial narrative that co-exists alongside the evolution of institutions. On the one hand, it is effective institutions that enable innovative technologies to be produced in the first place. On the other hand, technologies themselves inevitably become institution-killers.

Imagine, for instance, if cellphones had existed when long-distance trade emerged. If traders were able to keep better track of their shipments, they could opt to hire the best negotiators in town to shepherd their cargo, rather than their nephews. If some of us fear that governments have too much power today to seize our assets or arbitrarily change their value, we might opt to store value in decentralized, digital currencies. However, in this case, we might expose ourselves to digital pirates or brigands who may succeed in robbing us of our balances. Whether new institutions or new technologies will be created to confront these challenges, we are yet to see.

One thing is certain — the infinite game continues!