Institutions”. journal of economic perspectives 5 (1): 97-112

Institutions

Douglass C. North

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 andreduce 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 whichthe 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. In this essay I intend to elaborate on the role of institutions in the performance of economies and illustrate my analysis fromeconomic history.
What makes it necessary to constrain human interaction with institutions? The issue can be most succinctly summarized in a game theoretic context. 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 ofplayers. 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.

These polar extremes reflect contrasting economic settings in real life. There are many examples of simple exchange institutions that permit low cost transacting under theformer conditions. But institutions that permit low cost transacting and producing in a world of specialization and division of labor require solving the problems of human cooperation under the latter conditions.
It takes resources to define and enforce exchange agreements. Even if everyone had the same objective function (like maximizing the firm's profits), transacting would take substantialresources; but in the context of individual wealth-maximizing behavior and asymmetric information about the valuable attributes of what is being exchanged (or the performance of agents), transaction
costs are a critical determinant of economic performance. Institutions and the effectiveness of enforcement (together with the technology employed) determine the cost of transacting. Effectiveinstitutions raise the benefits of cooperative solutions or the costs of defection, to use game theoretic terms. In transaction cost terms, institutions reduce transaction and production costs per exchange so that the potential gains from trade are realizeable. Both political and economic institutions are essential parts of an effective institutional matrix.
The major focus of the literature oninstitutions and transaction costs has been on institutions as efficient solutions to problems of organization in a competitive framework (Williamson, 1975; 1985). Thus market exchange, franchising, or vertical integration are conceived in this literature as efficient solutions to the complex problems confronting entrepreneurs under various competitive conditions. Valuable as this work has been, such anapproach assumes away the central concern of this essay: to explain the varied performance of economies both over time and in the current world.
How does an economy achieve the efficient, competitive markets assumed in the foregoing approach? The formal economic constraints or property rights are specified and enforced by political institutions, and the literature simply takes those as a given....