TCS Daily

Due North

By Arnold Kling - June 13, 2007 12:00 AM

"When applied to economic history and development [mainstream economics] focused on technological development and more recently human capital investment, but ignored the incentive structure embodied in institutions that determined the extent of societal investment in those factors. In the analysis of economic performance through time it contained two erroneous assumptions: one that institutions do not matter and two that time does not matter.

...if the institutional framework rewards piracy then piratical organizations will come into existence; and if the institutional framework rewards productive activities then organizations - firms - will come into existence to engage in productive activities."
-- Douglass C. North, Economic Performance Through Time, the 1993 Economics Nobel Prize lecture

Douglass North could be the most important economist of the past fifty years. Yet, notwithstanding his Nobel Prize, North's work is little known and little recognized, even within the economics profession.

In the 1930's, when the most important economic problem was the Great Depression, a large swath of the younger part of the economics profession dropped everything in order to study, analyze, and develop the ideas proposed by John Maynard Keynes. Today, Douglass North ought to be receiving that same level of attention. The most important economic problems we face are complex systemic issues, such as underdevelopment in Africa or the financial stresses caused by health care spending in the United States. For these sorts of issues, Douglass North is as important as Keynes was to macroeconomics. However, hardly any young economists have followed North's path.

Douglass North calls attention to three factors that are ignored by mainstream economists.

-- Institutions
-- Adaptation
-- Beliefs

In textbook economics, the only external environmental factors that affect the individual are technology and prices. Social norms, habits, and rules play no role. North shows that institutions are fundamental determinants of poverty and prosperity. This essay will explain what North means by institutions and why they are so central.

Textbook economics treats the economy as an allocative mechanism. The focus is on the extent to which resources are allocated efficiently and equitably. North treats the economy as an adaptive mechanism. As an economic historian, his focus is on how an economy evolves over the long term, constrained in many ways by its past. My next essay will look at this aspect of North's approach.

Finally, textbook economics is devoid of cultural context. Mainstream economics assumes that any policy can be implemented anywhere at any time. In contrast, North sees economic behavior as anchored by institutions, which in turn are anchored by beliefs within the culture. My third essay will look at health care reform from this perspective.

I have not made an exhaustive study of North's career. I have read: Structure and Change in Economic History, published in 1981; Understanding the Process of Economic Change, published in 2005; his Nobel Prize lecture, quoted above; the recent papers cited in my essay Iraq's Natural State; and an essay from a conference volume that I discussed in a blog post. Although this hardly makes me feel like an expert, the vast majority of my colleagues in economics know even less of North's work than I do. In that sense, I may be reasonably well qualified to be the one to try to give him his due for a general audience.

New Institutional Economics

Late in 2005, Ron Bailey reported on a massive study by the World Bank on wealth in different countries. The economists who undertook the study divided national wealth into three components: natural resources; produced capital (such as steel mills or power plants); and something that they called intangible capital. They reported that for high-income countries like the United States, 80 percent of wealth is in this intangible form. Below is a table with their findings for a few countries.


Wealth per capita

Natural Resources

Produced Capital




2 %

14 %

84 %

United States


3 %

16 %

82 %



265 %

180 %

-346 %

One question that immediately jumps out from the table is this: what does it mean that the intangible share of wealth in the Congo is -346 percent? For that matter, what does it mean that the intangible share is 84 percent in Denmark and 82 percent in the U.S.?

A country's intangible wealth can be thought of as the difference between the present value of the country's future output and the value of its tangible assets, meaning natural resources and produced capital. Because it is calculated as a residual, intangible capital is sometimes just called "the residual."

In advanced countries, intangible capital, or the residual, includes skills and know-how -- what economists call human capital. But skills and know-how cannot be below zero, so the low wealth and the large negative residual for the Congo cannot be explained by human capital.

Only Douglass North and his adherents have an explanation for the enormous variation across countries in intangible capital. North focuses on institutions, including property rights, the behavior of government officials, and trading methods. Where these institutions serve to reward work, innovation, and risk-taking, the residual is positive. Where these institutions serve to reward theft and expropriation, the residual is negative. When government will expropriate any wealth that people create, the present value of future output can actually be less than the value of the country's tangible resources. The power of predatory government to destroy wealth is truly awesome.

Individual decisions are influenced by internal factors and by the external environment. In textbook economics, the external environment is greatly simplified. It presents individuals only with technologies and prices that pertain to goods, services, occupations, and investment opportunities. You choose what to buy, where to work, and how to invest based on the technologies and prices that are given. You make these choices based on your own personal tastes and endowments (wealth, abilities, skills). (More recently, the subfield of behavioral economics has studied information shortfalls, cognitive biases, and inconsistent preferences as factors that influence individual choices, but it retains a restricted view of the external environment.)

According to North, treating the external environment as nothing but a set of technologies and prices is a gross mis-specification. Instead, we have all sorts of formal and informal codes that constrain our behavior. Those are the institutions that are central to his work.

The bumper sticker for Douglass North is "the new institutional economics." Unfortunately, that bumper sticker has not worked to convey his ideas even within the economics profession. Most economists find it a challenge to incorporate the concept of institutions into their thinking, in part because they have difficulty pinning down a definition for "institution." In his Nobel lecture, North offers this:

Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics. Together they define the incentive structure of societies and specifically economies.

Later, he clarifies the difference between an organization and an institution.

It is the interaction between institutions and organizations that shapes the institutional evolution of an economy. If institutions are the rules of the game, organizations and their entrepreneurs are the players.

Textbook Assumptions vs. Institutional Economics

When you make a purchase online, textbook economics is able to relate your decision to buy to the cost of producing the item. But textbook economics says nothing about the role of an intermediary, such as Amazon or eBay, the role of a credit card company in facilitating the exchange, or the role of a package delivery service in fulfillment.

In real world economic activity, as opposed to the textbook setting, there are major complications concerning:

-- specification of property rights

-- monitoring and enforcement of behavior

For example, suppose that I order a used book that is represented as being in "very good" condition. Submitting the order creates a complex matrix of property rights involving the seller, the intermediary, the credit card company, the package delivery service, and me. In the early 1990's, these property rights were not spelled out very clearly. Getting the issues sorted out was a key hurdle in making Internet commerce possible.

This hypothetical purchase also raises issues of monitoring and enforcement. The seller might not send the book. The package service might not deliver it. I might claim that it was never received, or that it is not in good condition. A variety of monitoring devices and enforcement mechanisms are needed to make the process reliable.

The textbook story assumes the following:

-- Any problems that arise with property rights specification and with monitoring and enforcement are unusual and isolated;
-- The private sector cannot address such problems;
-- When government does step in with a solution, that takes care of the problem.

In Douglass North's economics:

-- Problems with property rights specification and with monitoring and enforcement are ubiquitous and inevitable;
-- A large share of private sector resources is devoted to addressing these problems;
-- Government involvement transforms those problems, but it does not eliminate them.

According to North, there is no ultimate solution to the problems of property rights, monitoring, and enforcement. Government may or may not make property rights less ambiguous. Monitoring and enforcement of government solutions may or may not be more effective than monitoring and enforcement of private solutions.

The Integrators

In the private sector, the functions of specifying property rights and undertaking monitoring and enforcement are performed by what I might call integrators. Integrators are people who are devoted either to the management process within firms or the process of exchange between firms. These integrators produce nothing themselves, but they help make everyone else more productive.

For example, when you make your Internet purchase, neither the seller, the credit card company, nor the package delivery service actually produces the good. Yet they play a key role in integrating the process. As North puts it,

The movement from personal to impersonal exchange always increases total transaction costs but the consequence is a drastic reduction in production costs, which more than offsets the increased resources going into transacting. (Understanding the Process of Economic Change, p. 91)

North presents a chart showing that the share of American output that represents transaction processing rose from less than 25 percent in 1870 to roughly 50 percent in 2000. He writes,

Banking, insurance, finance, wholesale and retail trade, as well as a good part of government activity are all part of the transaction sector. And then inside the firm there are ever increasing numbers of accountants, lawyers, and others devoted to facilitating exchange

The other integrators are managers within firms. North argues that the basic reason that production moved out of the home was to take advantage of the efficiency of standardization and teamwork. However, this requires management.

the impetus for the factory system was monitoring of the production process by a supervisor...the role of the monitor is to "rationalize" each step...devising means to measure the output and input of each unit and of creating more productive combinations. (Structure and Change in Economic History, p. 169)

Why do we not see more telecommuting? A reasonable hypothesis is that telecommuting raises the cost of monitoring and co-ordinating the work force. The managers responsible for integrating the work of an office can do their jobs more easily when their staffs are on site. That is not to suggest that telecommuting is a bad idea, or that it will not become increasingly important. However, as of today, the institutional alternatives to on-site monitoring and coordination are not mature.

In short, integration is the process of developing and executing solutions to the ubiquitous problems of imperfect property rights specification, monitoring, and enforcement. The more complex the economy becomes, the more important is the function of integration. Integration takes place inside the firm through supervision and management. Integration takes place across firms through standard-setting, specification, and contracting.

Integration and Market Failure

Textbook economics assumes away the problems that integrators seek to address. When mainstream economists stumble on an issue that requires integration, they pronounce this a "market failure." They treat market failures as exceptions that require government intervention.

For Douglass North, the challenges of integration are more the rule than the exception. He writes,

this [textbook] formulation appears to beg all of the interesting questions. The world with which it is concerned is a frictionless one in which institutions do not exist...the model assumes an incentive structure that will allow individuals to capture the returns to society of investment at all these margins, that is, private and social returns are equated...perfectly specified and costlessly enforced property rights (that is, zero transaction costs) are necessary...Such conditions have never obtained (Structure and Change, p. 5)

Moreover, although government can and does get involved with issues of integration, private sector alternatives also exist. In addition to supervisors and trading firms, there are standard-setting bodies and compliance certification organizations, such as Underwriters Laboratories. If you have been involved with personal computers over the past two decades, you have seen the evolution of standards for integration, including motherboard expansion slots, serial and parallel ports, USB ports, and wireless interfaces. Government was not the driver in setting these standards.

The structure of the Internet would make an interesting case study in the area of imperfect property rights. Every spam email I receive is proof that I do not own my inbox. However, government has a very difficult time intervening to stop spammers. It is difficult to define spam, in part because the same ad that irritates you is being answered by other recipients. As a joke points out, we cannot outlaw spam without causing egregious suffering to the consumers of penis-enlargement products. Even if spam were outlawed, it is difficult to enforce anti-spam laws, given the international character of the Internet, the ease of disguising identity, and the basic architectural decisions that make the Internet a stupid network, meaning one where the evaluation of the content of messages occurs at the endpoints, not in the middle.

What Behavior Gets Rewarded?

Whether an institution is grounded in private organizations or government policy, the key question is what behavior the institution rewards. In the view of Douglass North, incentives are never aligned perfectly. The challenge is to improve the alignment between incentives and desired outcomes.

For example, in a corporation, it is not uncommon for sales personnel to be paid based on volume, with another department -- say, finance -- accountable for profit margin. This puts the finance department and the sales department into conflict -- the bean-counters want high prices and the commission-hungry sales force wants lower prices. Their incentives are not aligned. The trick for senior management is to set goals for individuals that are easily measured and understood yet do not create adverse incentives. Because no compensation system solves every problem, companies tweak their bonus criteria constantly.

The incentives of producers and consumers are not automatically aligned. The institutional arrangements involved in a purchase over the Internet have evolved as various intermediaries have tried to bring about the best alignment at minimal cost. Reputation systems, where buyers rate sellers, are an interesting innovation, and the design of systems that resist manipulation still represents a challenge.

Government regulates and inspects many goods and services. In principle, government involvement serves to address a potential incentive for meatpackers to be careless of health considerations, for uneducated individuals to practice medicine, for service stations to sell diluted gasoline, and so on. On the other hand, these sorts of regulations may be used by producers to try to exclude legitimate competition.

This attempt to manipulate regulatory mechanisms exists whether regulations are administered by private organizations or by the government. There is as much incentive for colleges to try to manipulate their rankings in magazines as there is for schools to try to manipulate student performance on government-administered tests. There is no perfect, costless way to ensure that incentives work properly.

When it comes to implementing institutions, the government's main advantage is enforcement power. As the controversy over illegal immigration vividly illustrates, government is not necessarily a reliable enforcer. But in terms of the tools at its disposal, government's enforcement capability exceeds that of the private sector.

The private sector's main advantage in institution-building is in its adaptation mechanism. That is the topic for the next essay.

Arnold Kling is author of Learning Economics.



From the start I though that you would discuss norms of behavior...
...Norms or un-written rules fascinate me. I wonder about what role they play in the economy. I lived in Honduras for a while and it seems to me a society where people are more fearful of others than in the USA. It seems to me that this mistrust can cause an adverse I better get them before they get me attitude that can hamper economic growth.

BTW related: I was amazed in post Katrina New Orleans at how the assumptions of Americans about what would happen if all governmental restraint was removed, as evidenced by the reported showed far great expectations of barbarism than really happened.

IMO Social norms can be very strong and effective. I wonder if North talk about these sorts of norms.

Internet commerce would not have happened if all those involved didn't make special effort to ensure trust.
Trust that your credit card number was sucure.
Trust that the product met quality standards.

But that is an "intangeble" for all economies.

To the degree that societies trust those institutions, the freer and more successful the economy.

One element of that trust is identitification of illegal aliens. Every day thousands of illegal alians around the country are arrested for driving without a license or insurance. If they don't give a real name, have no documentation and are let back on the street to appear in court at a later date, how will the governemtt find them? Those who follow the law would pay, those who don't, won't.

Bush and many at TCS want to ID all illegals ASAP without regard for those who are waiting. This may add trust to the economy (they will have legal IDs), but no trust of government laws, which is the underpinning of any economy, trust in the currency and trust that the government will enforce laws equitably.

Fool me once, shame on you. Fool me twice, shame on me.

Institutions and Predictable Behavior
"Institutions are the humanly devised constraints that structure human interaction. They...define the incentive structure of societies and specifically economies."

A lone man on an island has incentives (to eat, drink, find shelter, have some fun, avoid preditors, etc...) without the guidance of any institutions. While existing institutions almost always mediate incentive expression, they generally do not FULLY define or determine incentives, incentive structure or rational economic behavior. Even in the most totolitarian societies of history, human/economic behavior has generally lacked full predictability. Bacteria and insects are more predictable than humans.

In my view, social norms comprise a framework of unwritten agreements that people enforce amongst themselves. For social norms to work, though, most people must be more loyal and committed to them than they are to their own personal interests and conveniences such that they both readily enforce and accept the enforcement of social norms. For example, adults can't pick their noses in public. When it happens, adults readily impose shame and accept it no matter what condition their sinuses happen to be in, thereby maintaining the agreed norm.

In most European code legal systems, prevailing commercial norms are included in the terms of every contract unless specifically excluded by law, contract or the course of performance. In common law systems, however, this is not so much the case, explaining why American and English contracts tend to be so unnecessarily long, wordy and complex to most Europeans.

North is right. The framework of unwritten norms that arise through agreement, loyalty and private enforcement provide much stronger, pervasive and generally acceptable institutions than does novel legislation.

I don't see why the author thinks this guy is so special. Anything I've ever heard about him doesn't show any special insights. If fact he seems to just complicate simpler issues. Like if middlemen ebay say, if they weren't reliable, nobody would use the service. Such institutions of handling human interactions are all over the place and don't need government interference. And the main difference between Denmark and the US and Congo, is that the first two have more economic freedom and capitalism. Also, the author annoyinly keeps saying, 'the textbook' economics, or answer; but most of the textbooks are left wing biased so for sure they don't like free markets. The best thing about North perhaps is the fact that the liberal economists Jeffrey Sachs(the guy who thinks that even tho we spent about a trillion on aid to africa just to make it poorer, we should spend another trillion or so) doesn't like him.

North considers Friedrich Hayek to the be greatest economist of all time. Small wonder considering North's interests.

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