Economists for Consideration: Introductions to Economic Thought and Ideas

12th Grade Honors/AP Macroeconomics

Lesson: Douglass North and Economic Institutions

Unit: First Principles of Macroeconomics

Enduring Understanding/ Essential Question(s):

How do institutions affect economic decision-making? Furthermore, how do relationships between

institutions and incentives impact economic growth? Why is it more difficult to change informal institutions

than formal institutions? How do economies develop over time? How can history and an understanding of

cognitive processes help us to solve the problems of economic development? These are some of the big

questions that Nobel laureate, professor, and economic historian Douglass North has tackled for decades.

In this set of lessons, students will come to answer these and related questions via an exploration of Douglass

North's work on the economic concepts of institutions, incentives and economic growth. Students will begin

by coming to understand that people respond to incentives and their related institutions while grappling with

the fact that culture plays a large role in determining economic outcomes. Once a foundation of

understanding has been established, students will tackle two texts by Douglass North that provide breadth

and depth to the ideas under study. By reading, summarizing and discussing North's work, students will be

able to grasp an analytical framework through which we can understand economic change through time,

which can help us shape the present and future.

Key Vocabulary: institutions, incentives, economic growth

Objective(s):

SWBAto

• Define institutions and provide one example each of a formal and informal institution that impacts

their lives, along with the related enforcement mechanisms.

• Define incentives and provide a related incentive for each of the formal and informal institutions that

impact their lives, and specify the nature of that incentive (positive or negative, monetary or non-

monetary).

• Differentiate between formal and informal institutions by explaining why it is more difficult to change

informal institutions than formal institutions.

• Explain in writing how relationships between incentives and institutions, history, perceptions, and

culture impact economic growth by answering six study questions about Douglass North's short essay

History Matters.

• Summarize one section of Douglass North's 1993 Nobel lecture.

• Write and answer two short essay questions about two different sections of Douglass North's 1993

Nobel lecture.

ISBE Economics Standards Addressed:

15.A.5a Explain the impact of various determinants of economic growth (e.g., investments in human/physical

capital, research and development, technological change) on the economy.

15.B.3b Explain the effects of choice and competition on individuals and the economy as a whole.

15.D.5a Explain how transaction costs affect decisions to produce or consume.

Materials: computer with internet connection, projector, handouts of Douglass North's History Matters essay

(with discussion questions) handouts of Douglass North's Nobel laureate speech

Time Allotted / # of students: Two 75 min. class sessions (block schedule) / 21 students

Procedures:

SESSION ONE

Anticipatory Set: Inquiry - What are institutions and how are they related to incentives? (15 min.)

- The teacher will project the following and inform students they have 5 minutes to complete the

exercise:

Institutions: Institutions are the rules that help direct our decision-making. They can be formal (laws and

regulations) - put in place by government agencies. And they also can be informal (beliefs & norms) - put in

place by social/religious, trade and family groups. In both cases, enforcement mechanisms exist that

legitimize the use or practice of institutions.

Provide one example of a formal institution that impacts your life, along with the enforcement

mechanism that legitimizes it.

o Example: The speed limit on highways. The Illinois State Police legitimizes and enforces this

institution through written laws and the power to issue citations and arrest.

Provide one example of an informal institution that impacts your life, along with the enforcement

mechanism that legitimizes it.

o Example: I look after my next-door neighbor's house when she's away. Where I come from, this

is perceived as something positive and legitimate to do. If I didn't do it, I would feel ashamed

and get a bad reputation in my neighborhood.

The teacher will debrief the students and check for understanding by soliciting examples from

students.

Next, the teacher will project the following and inform students they have 3 minutes to complete the

exercise:

Incentives: Incentives are the costs or benefits that motivate decisions or actions. People respond to

incentives. There are both monetary and nonmonetary incentives. Incentives can be positive or negative.

For each of your previous answers, provide one example of a related incentive, which can be positive

or negative, monetary or nonmonetary. Examples:

o Formal - If I'm caught speeding on the Dan Ryan, I am issued a ticket that I must pay - a

negative monetary incentive.

o Informal - I feel good that my neighbor appreciates my help and she brings me fresh fruit and

vegetables from Michigan once in awhile because of it - a positive, non-monetary incentive.

The teacher will debrief the students and check for understanding by soliciting examples from

students.

- The teacher will inform students that as they have demonstrated with their examples, "Institutions and

incentives are related! They do not exist without each other!

Inquiry and discussion - conflict between formal and informal institutions: a look at institutionalized bribery

and corruption in Eastern Europe (25 min.)

NOTE: this activity depends largely on the author's experience as a Peace Corps Volunteer in Romania. It will

have to be adapted if implemented by someone else.

The teacher asks students: "Have you ever paid a bribe? Have you ever been offered a bribe?" "I

have. I'll tell you more in a bit."

Visual scaffold - Eastern Europe. Teacher uses Google Earth to "fly" to Romania, and then pulls back to

a view that includes Hungary and Ukraine.

"As you all know, I was a teacher and Peace Corps Volunteer in Romania." "While there and traveling

through the region, I encountered and had to deal with institutions that we Americans do not usually

encounter in our daily lives - those being corruption and transactions involving bribes." The teacher

uses the map to show where he lived and traveled to.

- Teacher pulls up a short film from Hungary - http://www.voutube.com/watch?v=ebX8FTNuzec

"Watch this short film. There are no words. Pay attention to the setting, symbolism and action. Ask

yourself the following questions while watching: What is happening? Where are they? Who are these

characters? What point is the filmmaker attempting to make?

Following the short film, the teacher asks students, "Are formal or informal institutions, or both

present in the film? What incentives were at work in the film? Were they positive or negative,

monetary or nonmonetary?"

- Teacher shows students the young filmmaker's YouTube comment: "/ made this short film for an anti-

corruption video contest. The task was: you need to make a 1-2 minute long movie about corruption."

Teacher asks students, "Is corruption a formal or informal institution?"

- Teacher shows students his "Nu da spaga" (don't give bribes) folder to show students. Teacher

explains that "Nu da spaga" was a national campaign, sponsored by the European Union, to address

and eradicate corruption and bribery in Romania.

- Teacher will show students a TV commercial from the "Nu Da Spaga" campaign and translate.

http://www.youtube.com/watch?v=eC u7QK9TrE

Before showing the video, the teacher will scaffold understanding by explaining culture of corruption in

Romania. He will tell them his experiences with bribery at school and the police station. He will ask

students to pay close attention to the characters in the video that enter the apartment. What

professions do they represent?

- Teacher will debrief students on video to check for understanding.

- Teacher will point out that there was a reason that the ad chose to depict a police officer, nurse and a

teacher - bribery pervades the institutions of law enforcement, healthcare and education in Romania.

You are expected to give bribes, but never asked. Similar expectations exist in Hungary as well.

Teacher will also, tell them about his experience paying bribes when crossing the Ukrainian border.

- Teacher will ask students, "Is it particularly nefarious that such corruption exists within these three

particular institutions? Why or why not? These societies are much older than ours, so why are such

practices so widespread there and not here? [history of changing power structures, foreign

dominance, communism; rule of law and democracy not organically developed] Could you imagine

being expected to pay bribes in order to get optimal outcomes within such institutions here in the

U.S.? Why do such practices not happen frequently (we assume) in the U.S.? How is it that we

Americans came to have such faith in our core institutions? [rule of law and enforcement]"

- Teacher will ask, "Can commercials and advertisements change informal institutions like bribery and

corruption? Why or why not? If formal institutions can be thought of as "rules" and informal

institutions as "norms", which is easier to change? Why? [Point out that European Union, Hungarian

and Romanian laws deem bribery and acceptance of bribes as illegal, yet the practices are still

pervasive].

- Teacher reads students this quote: "You can change formal rules, but they don't get internalized for a

long, long time. And as a result, some people will find incentives for circumventing them. Informal

institutions, while often not having the power of law, can be just as effective. Formal rules may exist,

but they usually take a long time to become internalized."1

Mini-Lecture: Douglass North (10 min.)

NOTE: Subsequent information will be delivered via lecture. The Teacher has the option of using a whiteboard,

overhead, or CPU projector to write down or display key points from the information set forth below.

Optimally, the teacher would create a power point presentation for this segment, using the information set

forth below.

One of the things that North is known for are studies on how institutions (of all kinds) affect decisions,

and how institutions can change behavior2.

He uses history as the foundation for understanding institutions, how they change over time, and how

they impacts economic growth, stagnation and/or decline.

Douglass North shared the 1993 Nobel Prize in economics with Robert Fogel "for having renewed

research in economic history by applying economic theory and quantitative methods in order to

explain economic and institutional change."3

- In 1961, North published The Economic Growth of the United States from 1790 to 1860. In it he showed

how one sector of the economy, cotton plantations, stimulated economic development in other

sectors and led to specialization and interregional trade.4

- In 1968, North published an article showing that organizational change was more important than

technological change in increasing productivity in ocean shipping.5

'ibid.2 Prof. Tim Schilling.' The Concise Encyclopedia of Economics http://www.econlib.org/library/Enc/bios/North.html

4 Ibid.

In the 1970s, after showing that institutions, especially property rights, were important factors in

economic growth, North's work came to be known as "the new institutional economics"6.

North hypothesized that when various groups in society see a chance to make higher profits that are

impossible to earn within existing institutional arrangements, they will get together and change the

institutions to make these higher profits possible.7 (i.e. American Revolution)

In the late 1980s and early 1990s, North came to question his earlier belief that pro-growth

institutional changes will necessarily occur. He argued that societies can sometimes be locked into

dysfunctional institutions, such as absence of the rule of law and a judicial system that does a poor job

of enforcing contracts and property rights. When that happens, reasoned North, it is often very hard to

build the coalitions needed to reform these institutions.8 (Teacher: "What are some contemporary

examples? How does this relate to what we learned about Eastern Europe?")

Read-Aloud - History Matters by Douglass North (25 min.)

Teacher will give a copy of the essay (see separate document) to each student.

The teacher will read the essay aloud to the students.

Subsequently, the students will work in pairs to answer the discussion questions found at the end of

the essay.

Teacher will debrief students, solicit answers and check for understanding.

Teacher: "Keep these points in mind, because tomorrow we're going to go deeper and dig into the

details behind the main points of North's short essay by taking a look at his 1993 Nobel laureate

speech."

- Teacher: "Don't forget to bring your essay handout to the next session"

SESSION TWO

Anticipatory set (10 min.)

Teacher: "Take a quick look at the History Matters essay. Write down one "golden nugget" or an idea

of North's that you think is important for us to understand. You have 3 minutes."

Teacher solicits answers from students and asks them to explain their respective choices.

- Teacher asks students to post their "golden nuggets" on the class Wikispace after the class session is

complete.

Jigsaw with student-generated summaries - Douglass North's 1993 Nobel Laureate Lecture (65 min.)

Each student will receive a copy of the Nobel lecture (see separate document). The lecture consists of seven

parts. Seven groups of three will each be assigned one part. The teacher will form these groups based on

ability and will assign each of the seven parts based on length & complexity in order to better ensure efficient

outcomes and understanding. The jigsaw reading will consist of four phases, as described below. NOTE:

during phases A, B, & C, the teacher will be moving from group to group and monitoring students' progress.

He will be available to answer questions and clarify meaning of vocabulary.

5 Ibid.6 Ibid.7 Ibid.8 Ibid.

Phases:

A. Students, in seven groups of three, will read their respective group's assigned section individually and

silently.

B. Each group will now work together to summarize their respective section. Each group must negotiate and

agree upon a one or two sentence summary of each paragraph in the section; taken as a whole - the "group

section summary". Each individual student must offer his/her own one sentence understanding/opinion of

the section or "my take". Each student must have the group section summary and his/her "take" written

down. Each student is now prepared to present his/her group's respective section to a larger group of seven

students.

C. Students form three groups of seven, with each student representing a section of the text. Beginning with

section I. and ending with section VII., each student will present his/her group's summary and his/her "take"

on his/her respective chapter. Students are responsible for taking notes when they are not presenting, with

the result being that each student will have a full, peer-generated summary of the text. Once all seven

sections have been completed, each of the three groups will negotiate and agree upon a one-sentence

understanding/summary of the entire text or "the group's take". Each group must select a representative to

go to the whiteboard and write down his/her group's "take" and will be asked to read it aloud to the class

when this phase is complete. Teacher will give feedback and check for understanding.

D. Now that each student is equipped with a peer-generated summary of the text (as well as the full text), the

teacher will debrief and check for understanding of the details. NOTE: the teacher will use a section summary

of the text (see separate document) to guide the debriefing discussion and fill in any gaps in students'

understanding. The teacher will also be sure to check for understanding of key vocabulary through direct

questioning during this time.

The teacher will go through the text, section by section and solicit responses from students in order to get a

point-by-point summary of each section. As students offer up information and opinions, the teacher will

make sure that other students can add to or challenge the offerings before they become part of the "official

record" of student understanding. The official record is a student-generated outline of the text that the

teacher will type up and project as the class creates it. Students may copy the official record in their

notebooks and/or take notes during this process. The official record will be posted on the class Wikispace as

soon as it is completed.

Homework Assessment

Equipped with a class-generated summary of the text (as well as the full text), each student must now write

two short-answer essay questions based on the text. Each question must be based upon information from

two different sections. Students are not permitted to write a question based upon the section they

summarized in the initial phases of the jigsaw. Each short-answer essay question must be accompanied by an

answer that is 3-5 sentences in length (one paragraph).

Following submission of the questions, the teacher will select one for each section of the text. The seven

selected questions will be compiled as a future summative assessment. Students are incentivized to write

good questions, as those students whose questions are selected will receive the points equivalent of 100%

credit for one section on their respective summative assessment. Such students will not be obliged to answer

their own question and will thus be responsible for 6 of the 7 questions.

History Matters by Douglass North, 2006

History matters. It matters not only because we can learn from the past, but because the

present and the future are connected to the past by the continuity of a society's institutions.

Today's and tomorrow's choices are shaped by the past. And the past can be made intelligible

only as a story of institutional evolution.

This story focuses on the problem of human cooperation - specifically, the cooperation that

permits economies to capture gains from trade. Economic growth depends upon the evolution

of institutions that create a hospitable environment for cooperative solutions to problems

associated with trade. Not all human cooperation is socially productive, of course; twentieth-

century history provides many examples of cooperative efforts undertaken in the service of ill-

advised or destructive goals. In analyzing human cooperation, therefore, we also need to be

concerned with the evolution of institutional frameworks that induce economic stagnation and

decline. The purpose in each case is to explain the structure and performance of economies

overtime.

Understanding the process of economic change would enable us to account for the diverse

performance of economies, past and present. We would, for example, be able to account for

the long history of sustained growth in the United States and western Europe; for the

spectacular rise and demise of the Soviet Union; for the performance of Taiwan and South

Korea, marked by rapid economic growth, in contrast to the dismal record of sub-Saharan

African economies; and for contrasts in the evolution of Latin America and North America.

Understanding the past has its own value for those who seek to elaborate and refine theories of

economic growth. In addition, knowledge of the past is the key to improving the performance

of economies today and in the future. A real understanding of how economies grow can unlock

the door to greater human well-being through a reduction in abject poverty and misery.

We live in an uncertain world that evolves continually, in surprising ways. In this context,

standard theories - including neo-classical economic theory - are of little help, notwithstanding

their value for other purposes. Attempting to understand economic, political and social change

(we cannot grasp any one of these aspects apart from the others) requires a fundamental

recasting of the way we think. Can we develop a dynamic theory of change comparable in

elegance to general equilibrium theory? Probably not. But if we achieve an understanding of

the underlying process, then we can develop more limited hypotheses about change that can

enormously improve the usefulness of social science theory in confronting human problems.

Economic change is a process. In contrast to Darwinian evolutionary theory, the key element in

a theory of human evolutionary change must be the intentionality of the players. The selection

mechanisms in Darwinian theory are not informed by beliefs about the eventual consequences

of events that occur as species evolve. In contrast, human evolution is guided by the

perceptions of the players. The perceptions are influenced by the beliefs of the players - the

theories they hold about the consequences of their actions - and these beliefs typically are

blended with their preferences. The players make decisions in light of their perceptions, with

the intent of producing outcomes downstream that will reduce uncertainty arising from the

institutions they rely on - political, economic and social - as they pursue their goals. For the

most part, therefore, economic change is a deliberate process shaped by the perceptions of the

actors as they weigh the likely consequences of their choices and actions.

But how do humans come to understand their environment? The explanations they develop are

mental constructs derived from experiences, contemporary and historical. These constructs are

based on something more than the accumulation of individuals' experiences over their

lifetimes. They are also influenced by the cumulative experience of past generations.

The cumulative learning of a society - embodied in language, memory and symbol systems -

includes beliefs, myths and ways of doing things that make up the culture of a society. Culture

not only determines societal performance at a moment in time; through the way in which it

supports and constrains the players, it also contributes to the process of change over time. To

understand this process, therefore, we need to focus on human learning in a broad sense: on

what is learned and how it is shared among the members of a society; on the incremental

process by which the beliefs and preferences change; and on the way in which beliefs and

preferences shape the performance of economies over time.

We cannot expect high school students to fully appreciate how choices made by their ancestors

have fundamentally shaped the institutions with which we live today. They can, however, learn

to see events large and small as outcomes produced by the choices people make every day, and

they can begin to understand how those choices are shaped by evolving institutions and the

ideas on which the institutions are based.

Douglass C. North is the Hoover Institution's Bartlett Burnap Senior Fellow. His current research activities include

research on property rights, transaction costs, economic organization in history, a theory of the state, the free

rider problem, ideology, growth of government, economic and social change and a theory of institutional

change. North received the Nobel Prize in economics in 1993. He was elected a fellow of the British Academy in

July 1996 and was installed as the Spencer T. Olin Professor in Arts and Sciences at Washington University in

Saint Louis in October 1996.

Douglass North Nobel Prize Lecture

Lecture to the memory of Alfred Nobel, December 9,1993

Economic Performance through Time

Economic history is about the performance of economies through time. The objective of research in the

field is not only to shed new light on the economic past but also to contribute to economic theory by

providing an analytical framework that will enable us to understand economic change. A theory of

economic dynamics comparable in precision to general equilibrium theory would be the ideal tool of

analysis. In the absence of such a theory we can describe the characteristics of past economies, examine

the performance of economies at various times, and engage in comparative static analysis; but missing is

an analytical understanding of the way economies evolve through time. [1]

A theory of economic dynamics is also crucial for the field of economic development. There is no

mystery why the field of development has failed to develop during the five decades since the end of the

Second World War. Neo-classical theory is simply an inappropriate tool to analyze and prescribe policies

that will induce development. It is concerned with the operation of markets, not with how markets

develop. How can one prescribe policies when one doesn't understand how economies develop? The

very methods employed by neo-classical economists have dictated the subject matter and militated

against such a development. That theory in the pristine form that gave it mathematical precision and

elegance modeled a frictionless and static world. When applied to economic history and development it

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. [2]

This essay is about institutions and time. It does not provide a theory of economic dynamics comparable

to general equilibrium theory. We do not have such a theory.' Rather it provides the initial scaffolding of

an analytical framework capable of increasing our understanding of the historical evolution of

economies and a necessarily crude guide to policy in the ongoing task of improving the economic

performance of economies. The analytical framework is a modification of neo-classical theory. What it

retains is the fundamental assumption of scarcity and hence competition and the analytical tools of

micro-economic theory. What it modifies is the rationality assumption. What it adds is the dimension of

time. [3]

Institutions form the incentive structure of a society and the political and economic institutions, in

consequence, are the underlying determinant of economic performance. Time as it relates to economic

and societal change is the dimension in which the learning process of human beings shapes the way

institutions evolve. That is, the beliefs that individuals, groups, and societies hold which determine

choices are a consequence of learning through time - not just the span of an individual's life or of a

generation of a society but the learning embodied in individuals, groups, and societies that is cumulative

through time and passed on intergenerationally by the culture of a society. [4]

The next two sections of this essay summarize the work I, and others, have done on the nature of

institutions and the way they affect economic performance (II) and then characterize the nature of

institutional change (III). The remaining four sections describe a cognitive science approach to human

learning (IV); provide an institutional/cognitive approach to economic history (V); indicate the

implications of this approach for improving our understanding of the past (VI); and finally suggest

implications for current development policies (VII). [5] *do not summarize this paragraph

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. Institutions and the technology employed

determine the transaction and transformation costs that add up to the costs of production. It was

Ronald Coase (1960) who made the crucial connection between institutions, transaction costs, and neo-

classical theory. The neo-classical result of efficient markets only obtains when it is costless to transact.

Only under the conditions of costless bargaining will the actors reach the solution that maximizes

aggregate income regardless of the institutional arrangements. When it is costly to transact then

institutions matter. And it is costly to transact. Wallis and North (1986) demonstrated in an empirical

study that 45 percent of U.S. GNP was devoted to the transaction sector in 1970. Efficient markets are

created in the real world when competition is strong enough via arbitrage and efficient information

feedback to approximate the Coase zero transaction cost conditions and the parties can realize the gains

from trade inherent in the neo-classical argument. [1] *a three sentence summary is permitted for this paragraph

But the informational and institutional requirements necessary to achieve such efficient markets are

stringent. Players must not only have objectives but know the correct way to achieve them. But how do

the players know the correct way to achieve their objectives? The instrumental rationality answer is that

even though the actors may initially have diverse and erroneous models, the informational feedback

process and arbitraging actors will correct initially incorrect models, punish deviant behavior and lead

surviving players to correct models. [2]

An even more stringent implicit requirement of the discipline-of-the-competitive-market model is that

when there are significant transaction costs, the consequent institutions of the market will be designed

to induce the actors to acquire the essential information that will lead them to correct their models. The

implication is not only that institutions are designed to achieve efficient outcomes but that they can be

ignored in economic analysis because they play no independent role in economic performance. [3]

These are stringent requirements that are realized only very exceptionally. Individuals typically act on

incomplete information and with subjectively derived models that are frequently erroneous; the

information feedback is typically insufficient to correct these subjective models. Institutions are not

necessarily or even usually created to be socially efficient; rather they, or at least the formal rules, are

created to serve the interests of those with the bargaining power to create new rules. In a world of zero

transaction costs, bargaining strength does not affect the efficiency of outcomes; but in a world of

positive transaction costs it does. [4]

It is exceptional to find economic markets that approximate the conditions necessary for efficiency. It is

impossible to find political markets that do. The reason is straightforward. Transaction costs are the

costs of specifying what is being exchanged and of enforcing the consequent agreements. In economic

markets what is being specified (measured) is the valuable attributes - the physical and property rights

dimensions - of goods and services or the performance of agents. While measurement can frequently be

costly, there are some standard criteria: the physical dimensions have objective characteristics (size,

weight, color, etc.) and the property rights dimensions are defined in legal terms. Competition also plays

a critical role in reducing enforcement costs. The judicial system provides coercive enforcement. Still,

economic markets in the past and present are typically imperfect and beset by high transaction costs.

[5]

Measuring and enforcing agreements in political markets is far more difficult. What is being exchanged

(between constituents and legislators in a democracy) is promises for votes. The voter has little

incentive to become informed because the likelihood that one's vote matters is infinitesimal; further the

complexity of the issues produces genuine uncertainty. Enforcement of political agreements is beset by

difficulties. Competition is far less effective than in economic markets. For a variety of simple, easy-to-

measure and important-to-constituent-well-being policies, constituents may be well informed, but

beyond such straightforward policy issues ideological stereotyping takes over and (as I shall argue below

in section IV) shapes the consequent performance of economies.3 It is the polity that defines and

enforces property rights and in consequence it is not surprising that efficient economic markets are so

exceptional. [6]

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.

Organizations are made up of groups of individuals bound together by some common purpose to

achieve certain objectives. Organizations include political bodies (political parties, the Senate, a city

council, regulatory bodies), economic bodies (firms, trade unions, family farms, cooperatives), social

bodies (churches, clubs, athletic associations), educational bodies (schools, universities, vocational

training centers). [1]

The organizations that come into existence will reflect the opportunities provided by the institutional

matrix. That is, 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. [2]

Economic change is a ubiquitous, ongoing, incremental process that is a consequence of the choices

individual actors and entrepreneurs of organizations are making every day. While the vast majority of

these decisions are routine (Nelson and Winter, 1982) some involve altering existing "contracts"

between individuals and organizations. Sometimes that recontracting can be accomplished within the

existing structure of property rights and political rules; but sometimes new contracting forms require an

alteration in the rules. Equally, norms of behavior that guide exchanges will gradually be modified or

wither away. In both instances, institutions are being altered. [3]

Modifications occur because individuals perceive that they could do better by restructuring exchanges

(political or economic). The source of the changed perceptions may be exogenous to the economy - for

instance a change in the price or quality of a competitive product in another economy that alters

perceptions of entrepreneurs in the given economy about profitable opportunities. But the most

fundamental long run source of change is learning by individuals and entrepreneurs of organizations. [4]

While idle curiosity will result in learning, the rate of learning will reflect the intensity of competition

amongst organizations. Competition, reflecting ubiquitous scarcity, induces organizations to engage in

learning to survive. The degree of competition can and does vary. The greater the degree of monopoly

power the lower the incentive to learn. [5]

The speed of economic change is a function of the rate of learning but the direction of that change is a

function of the expected pay-offs to acquiring different kinds of knowledge. The mental models that the

players develop shape perceptions about the pay-offs. [6]

IV

It is necessary to dismantle the rationality assumption underlying economic theory in order to approach

constructively the nature of human learning. History demonstrates that ideas, ideologies, myths,

dogmas, and prejudices matter; and an understanding of the way they evolve is necessary for further

progress in developing a framework to understand societal change. The rational choice framework

assumes that individuals know what is in their self interest and act accordingly. That may be correct for

individuals making choices in the highly developed markets of modern economies4 but it is patently

false in making choices under conditions of uncertainty - the conditions that have characterized the

political and economic choices that shaped (and continue to shape) historical change. [1]

Herbert Simon has stated the issues succinctly:

If... we accept the proposition that both the knowledge and the computational power of the decision

maker are severely limited, then we must distinguish between the real world and the actor's perception

of it and reasoning about it. That is to say we must construct a theory (and test it empirically) of the

process of decision. Our theory must include not only the reasoning processes but also the processes

that generated the actor's subjective representation of the decision problem, his or her frame. (Simon,

1986, pp. (210-11) [2]

The analytical framework we must build, must originate in an understanding of how human learning

takes place. We have a way to go before we can construct such a theory but cognitive science has made

immense strides in recent years - enough strides to suggest a tentative approach that can help us

understand decision making under uncertainty. [3]

Learning entails developing a structure by which to interpret the varied signals received by the senses.

The initial architecture of the structure is genetic but the subsequent scaffolding is a result of the

experiences of the individual. The experiences can be classified into two kinds - those from the physical

environment and those from the socio-cultural linguistic environment. The structures consist of

categories - classifications that gradually evolve from earliest childhood to organize our perceptions and

keep track of our memory of analytic results and experiences. Building on these classifications, we form

mental models to explain and interpret the environment - typically in ways relevant to some goal. Both

the categories and the mental models will evolve, reflecting the feedback derived from new

experiences: feedback that sometimes strengthens our initial categories and models or may lead to

modifications - in short, learning. Thus, the mental models may be continually redefined with new

experiences, including contact with others' ideas. [4]

At this juncture the learning process of human beings diverges from that of other animals (such as the

sea slug - a favorite research subject of cognitive scientists) and particularly diverges from the computer

analogy that dominated early studies of artificial intelligence. The mind appears to order and reorder

the mental models from their special purpose origins to successively more abstract form so that they

become available to process other information. The term used by Clark and Karmiloff-Smith (1993) is

representational redescription. The capacity to generalize from the particular to the general and to use

analogy is a part of this redescription process. It is this capacity that is the source not only of creative

thinking but also of the ideologies and belief systems that underlie the choices humans make. [5]

A common cultural heritage provides a means of reducing the divergence in the mental models that

people in a society have, and constitutes the means for the intergenerational transfer of unifying

perceptions. In pre-modern societies cultural learning provided a means of internal communication; it

also provided shared explanations for phenomena outside the immediate experiences of the members

of society in the form of religions, myths and dogmas. Such belief structures are not, however, confined

to primitive societies but are an essential part of modern societies as well. [6]

Belief structures get transformed into societal and economic structures by institutions- both formal rules

and informal norms of behavior. The relationship between mental models and institutions is an intimate

one. Mental models are the internal representations that individual cognitive systems create to

interpret the environment; institutions are the external (to the mind) mechanisms individuals create to

structure and order the environment [7]

There is no guarantee that the beliefs and institutions that evolve through time will produce economic

growth. Let me pose the issue that time presents us by a brief institutional/cognitive story of long-run

economic/political change. [1]

As tribes evolved in different physical environments they developed different languages and, with

different experiences, different mental models to explain the world around them. The languages and

mental models formed the informal constraints that defined the institutional framework of the tribe and

were passed down inter-generationally as customs, taboos, and myths that provided cultural continuity.

[2]

With growing specialization and division of labor the tribes evolved into polities and economies; the

diversity of experience and learning produced increasingly different societies and civilizations with

different degrees of success in solving the fundamental economic problem of scarcity. The reason is that

as the complexity of the environment increased as human beings became increasingly interdependent,

more complex institutional structures were necessary to capture the potential gains from trade. Such

evolution requires that the society develop institutions that will permit anonymous, impersonal

exchange across time and space. To the extent that the culture and local experiences had produced

diverse institutions and belief systems with respect to the gains from such cooperation, the likelihood of

creating the necessary institutions to capture the gains from trade of more complex contracting varied.

In fact most societies throughout history got "stuck" in an institutional matrix that did not evolve into

the impersonal exchange essential to capturing the productivity gains that came from the specialization

and division of labor that have produced the Wealth of Nations. [3]

The key to the foregoing story is the kind of learning that the individuals in a society acquired through

time. Time in this context entails not only current experiences and learning but also the cumulative

experience of past generations that is embodied in culture. Collective learning - a term used by Hayek -

consists of those experiences that have passed the slow test of time and are embodied in our language,

institutions, technology, and ways of doing things. It is "the transmission in time of our accumulated

stock of knowledge" (Hayek 1960: 27). It is culture that provides the key to path dependence - a term

used to describe the powerful influence of the past on the present and future. The current learning of

any generation takes place within the context of the perceptions derived from collective learning.

Learning then is an incremental process filtered by the culture of a society which determines the

perceived pay-offs, but there is no guarantee that the cumulative past experience of a society will

necessarily fit them to solve new problems. Societies that get "stuck" embody belief systems and

institutions that fail to confront and solve new problems of societal complexity. [4]

We need to understand a great deal more about the cumulative learning of a society. The learning

process appears to be a function of 1) the way in which a given belief structure filters the information

derived from experiences; and 2) the different experiences confronting individuals and societies at

different times. The perceived rate of return (private) may be high to military technology (in medieval

Europe), to the pursuit and refinement of religious dogma (Rome during and after Constantine) or to the

research for an accurate chronometer to determine longitude at sea (for which a substantial reward was

offered during the age of exploration). [5]

The incentives to acquire pure knowledge, the essential underpinning of modern economic growth, are

affected by monetary rewards and punishments; they are also fundamentally influenced by a society's

tolerance of creative developments, as a long list of creative individuals from Galileo to Darwin could

attest. While there is a substantial literature on the origins and development of science, very little of it

deals with the links between institutional structure, belief systems and the incentives and disincentives

to acquire pure knowledge. A major factor in the development of Western Europe was the gradual

perception of the utility of research in pure science. [6]

Incentives embodied in belief systems as expressed in institutions determine economic performance

through time, and however we wish to define economic performance the historical record is clear.

Throughout most of history and for most societies in the past and present, economic performance has

been anything but satisfactory. Human beings have, by trial and error, learned how to make economies

perform better; but not only has this learning taken ten millenia (since the first economic revolution) - it

has still escaped the grasp of almost half of the world's population. Moreover the radical improvement

in economic performance, even when narrowly defined as material well-being, is a modern

phenomenon of the last few centuries and confined until the last few decades to a small part of the

world. Explaining the pace and direction of economic change throughout history presents a major

puzzle. [7]

Let us represent the human experience to date as a 24 hour clock in which the beginning consists of the

time (apparently in Africa between 4 and 5 million years ago) when humans became separate from

other primates. Then the beginning of so-called civilization occurs with the development of agriculture

and permanent settlement in about 8000 B.C. in the Fertile Crescent - in the last three or four minutes

of the clock. For the other twenty three hours and fifty six or seven minutes, humans remained hunters

and gatherers and while population grew it did so at a very slow pace. [8]

Now if we make a new 24 hour clock for the time of civilization - the ten thousand years from

development of agriculture to the present - the pace of change appears to be very slow for the first 12

hours although our archeological knowledge is very limited. Historical demographers speculate that the

rate of population growth may have doubled as compared to the previous era but still was very slow.

The pace of change accelerates in the past five thousand years with the rise and then decline of

economies and civilizations. Population may have grown from about three hundred million at the time

of Christ to about eight hundred million by 1750 - a substantial acceleration as compared to earlier rates

of growth. The last 250 years - just 35 minutes on our new 24 hour clock - are the era of modern

economic growth accompanied by a population explosion that now puts world population in excess of

five billion. If we focus now on the last 250 years we see that growth was largely restricted to Western

Europe and the overseas extensions of Britain for 200 of those 250 years. [9]

Not only has the pace varied over the ages; the change has not been unidirectional. That is not simply a

consequence of the decline of individual civilizations; there have been periods of apparent secular

stagnation - the most recent being the long hiatus between the end of the Roman Empire in the west

and the revival of Western Europe approximately five hundred years later. [10]

VI

What can an institutional/cognitive approach contribute to improving our understanding of the

economic past? First of all it should make sense out of the very uneven pattern of economic

performance described in the previous section. There is nothing automatic about the evolving of

conditions that will permit low cost transacting in the impersonal markets that are essential to

productive economies. Game theory characterizes the issue. Individuals will usually find it worthwhile

cooperating with others in exchange 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.

Cooperation is difficult to sustain when the game is not repeated (or there is an endgame), when

information about the other players is lacking, and when there are large numbers of players. Creating

the institutions that will alter the benefit/cost ratios in favor of cooperation in impersonal exchange is a

complex process because it not only entails the creation of economic institutions but requires that they

be undergirded by appropriate political institutions. [1]

We are just beginning to explore the nature of this historical process. The remarkable development of

Western Europe from relative backwardness in the tenth century to world economic hegemony by the

eighteenth century is a story of a gradually evolving belief system in the context of competition among

fragmented political/economic units producing economic institutions and political structure that

produced modern economic growth. And even within Western Europe there were successes (The

Netherlands and England) and failures (Spain and Portugal) reflecting diverse external environmental

experiences. [2]

Second, institutional/cognitive analysis should explain path dependence, one of the remarkable

regularities of history. Why do economies once on a path of growth or stagnation tend to persist?

Pioneering work on this subject is beginning to give us insights into the sources of path dependence

(Arthur, 1989 and David, 1985). But there is much that we still do not know. The rationality assumption

of neo-classical theory would suggest that political entrepreneurs of stagnating economies could simply

alter the rules and change the direction of failed economies. It is not that rulers have been unaware of

poor performance. Rather the difficulty of turning economies around is a function of the nature of

political markets and, underlying that, the belief systems of the actors. The long decline of Spain, for

example, from the glories of the Habsburg Empire of the sixteenth century to its sorry state under

Franco in the twentieth century was characterized by endless self appraisals and frequently bizarre

proposed solutions. [3]

Third, this approach will contribute to our understanding of the complex interplay between institutions,

technology, and demography in the overall process of economic change. A complete theory of economic

performance would entail such an integrated approach to economic history. We certainly have not put

all the pieces together yet. For example, Robert Fogel's path breaking work on demographic theoryll

and its historical implications for reevaluating past economic performance has yet to be fully integrated

with institutional analysis. The same is true for technological change. The important contributions of

Nathan Rosenberg (1976) and Joel Mokyr (1990), exploring the impetus for and consequences of

technological change have ongoing implications which need to be integrated with institutional analysis.

An essay by Wallis and North (forthcoming) is a beginning at integrating technological and institutional

analysis. But a major task of economic history is to integrate these separate strands of research. [4]

VII

We cannot account for the rise and decline of the Soviet Union and world communism with the tools of

neo-classical analysis, but we should with an institutional/cognitive approach to contemporary problems

of development. To do so - and to provide an analytical framework to understand economic change - we

must take into account the following implications of this approach: [1]

1. It is the admixture of formal rules, informal norms, and enforcement characteristics that shapes

economic performance. While the rules may be changed overnight, the informal norms usually change

only gradually. Since it is the norms that provide "legitimacy" to a set of rules, revolutionary change is

never as revolutionary as its supporters desire and performance will be different than anticipated. And

economies that adopt the formal rules of another economy will have very different performance

characteristics than the first economy because of different informal norms and enforcement. The

implication is that transferring the formal political and economic rules of successful western market

economies to Third World and eastern European economies is not a sufficient condition for good

economic performance. Privatization is not a panacea for solving poor economic performance. [2]

2. Polities significantly shape economic performance because they define and enforce the economic

rules. Therefore, an essential part of development policy is the creation of polities that will create and

enforce efficient property rights. However, we know very little about how to create such polities

because the new political economy (the new institutional economics applied to politics) has been largely

focused on the United States and developed polities. A pressing research need is to model Third World

and eastern European polities. However, the foregoing analysis does have some implications:

a. Political institutions will be stable only if undergirded by organizations with a stake in their

perpetuation.

b. Both institutions and belief systems must change for successful reform since it is the mental models

of the actors that will shape choices.

c. Developing norms of behavior that will support and legitimize new rules is a lengthy process and in

the absence of such reinforcing mechanisms polities will tend to be unstable.

d. While economic growth can occur in the short run with autocratic regimes, long run economic growth

entails the development of the rule of law.

e. Informal constraints (norms, conventions and codes of conduct) favorable to growth can sometimes

produce economic growth even with unstable or adverse political rules. The key is the degree to which

such adverse rules are enforced. [3] *a three sentence summary is permitted for this paragraph

3. It is adaptive rather than allocative efficiency which is the key to long run growth. Successful

political/economic systems have evolved flexible institutional structures that can survive the shocks and

changes that are a part of successful evolution. But these systems have been a product of long

gestation. We do not know how to create adaptive efficiency in the short run. [4]

We have just set out on the long road to achieving an understanding of economic performance through

time. The ongoing research embodying new hypotheses confronting historical evidence not only will

create an analytical framework enabling us to understand economic change through time; in the process

it will enrich economic theory enabling it to deal effectively with a wide range of contemporary issues

currently beyond its ken. The promise is there. The recognition of that promise by the Nobel Committee

should be the essential spur to move us on down that road. [5]

Section Summary of Douglass North's Nobel Lecture - Economic Performance through Time

Section I: Introduction

[1] We need an effective analytical framework through which to study the performance of

economies over time so that we can better understand economic change.

[2] Neo-classical economic theory, in its effort to "prescribe policies that induce development"

failed to recognize that institutions and time matter in analysis. Incentives determine the

character or make-up of institutions.

[3] This essay helps scaffold an analytical framework that is "capable of increasing our

understanding of the historical evolution of economies" and will help guide us in the "ongoing

task of improving the performance of economies".

[4] The relationship between incentives and institutions determines economic performance.

Beliefs are influenced by learning over time, determine our choices, and are passed on from

generation to generation by culture.

Section II: A summary of work done on the nature of institutions and their impact on

economic performance

[1] Institutions are made up of formal and informal constraints and their enforcement

characteristics. These three elements form incentive structures of societies and, specifically,

their economies. The interactions of institutions and technology determine transaction costs

that add up to production costs.

[2] "The informational and institutional requirements necessary to achieve efficient markets are

stringent." "Rational" economic analysis assumes that "surviving" players' behavior will lead to

"correct models" - i.e. survival of the fittest; those that have the best information.

[3] The "discipline of the competitive market model" implies that institutions are "designed to

achieve efficient outcomes", and thus "can be ignored in economic analysis".

[4] Yet, we know that institutions are not necessarily created to be "socially efficient";

"rather...the formal rules are created to serve the interests of those with the bargaining power

to create new rules." It is this bargaining power that affects the efficiency of outcomes in a

world with transaction costs, not necessarily the rules per se.

[5] Transaction costs involve measuring the value and enforcing the agreements related to the

physical dimensions and property rights of goods and services or the performance of agents. In

economic markets, the level of competition determines the transaction costs and judicial

systems provide "coercive enforcement".

[6] Measuring and enforcing agreements in political markets is far more difficult compared to

economic markets, as even a well-informed constituent is uncertain as to whether or not an

elected official will make good on his promises. Complexity of political, sociological and

economic issues inevitably leads to "ideological stereotyping" and "shapes the consequent

performance of economies".

Section III: The nature of institutional change

[1] Institutions (the rules of the game) interact with organizations and entrepreneurs (the

players) to shape the evolution of an economy. "Organizations are made up of groups of

individuals bound together by some common purpose to achieve certain objectives and can

include political bodies, economic bodies, social bodies and educational bodies."

[2] Organizations reflect the opportunities provided by the "institutional matrix", i.e. the

interplay of formal rules and informal norms.

[3] "Economic change is an ongoing process that is a consequence of the choices individual

actors and entrepreneurs of organizations make every day." These choices (or exchanges) are

influenced by rules (for example, contracts) that change over time. As the rules change, so do

the institutions.

[4] Changes occur because individuals get new information and perceive that they could do

better. In the long-run, change happens because of individuals' and entrepreneurs' of

organizations learning.

[5] "The rate of learning will reflect the intensity of competition amongst organizations - which

reflects scarcity - thus inducing organizations to engage in learning to survive." "The greater the

degree of monopoly power, the lower the incentive to learn."

[6] How fast change occurs depends upon the rate of learning, but the direction of that change

depends upon how people perceive the "pay-offs to acquiring different knowledge", i.e. are

there positive incentives to learn and change?

Section IV: A cognitive science approach to human learning

[1] History shows us that "ideas, ideologies, myths, dogmas and prejudices" impact how we

human beings learn. A question we must ask ourselves is: do individuals always know what is in

their self-interest and thus act accordingly?

[2] Furthermore, is there a difference between the real world and the decision-maker's

perception of and reasoning about it? How do we come to make decisions?

[3] The analytical framework we must build should "originate in an understanding of how

human learning takes place". This way, we can come to better know how people make

decisions when faced with uncertainty.

[4] Experiences and language help us form "mental models" to explain and interpret our

environment, which are subsequently categorized within our minds. These mental models,

categories and our interpretation of our environment evolve as we get feedback from our

experiences and come into contact with others' ideas - "in short, learning".

[5] Our capacity to order and reorder the mental models helps us "make space available to

process other information". Furthermore, our capacity to use analogies reflect creative

thinking and the "ideologies and belief systems that underlie the choices humans make."

[6] "A common cultural heritage helps prevent divergence from mental models that people in a

society have and provides a means of internal communication and shared explanations for

phenomena outside the immediate experiences of the members of that society." It is from this

circumstance that belief structures are created.

[7] "Belief structures get transformed into societal and economic structures by institutions -

both formal and informal norms of behavior." "Institutions are the external (to the mind)

mechanisms individuals create to structure and order their environment."

Section V: An institutional/cognitive approach to economic history

[1] "There is no guarantee that the beliefs and institutions that evolve through time will

produce economic growth."

[2] Tribes' different circumstances determined different institutional frameworks, which were

passed down from generation to generation and formed cultural continuity.

[3] As societies became more complex and human beings become more interdependent, their

levels of economic growth were determined by the evolution of their institutions. If the

institutions facilitated "impersonal exchange" they grew economically - if not, they remained

"stuck".

[4] "Collective learning" forms culture, which determines "path dependence" -or, how much

the past influences the present and the future. "Societies that get 'stuck' embody belief

systems and institutions that fail to confront and solve new problems of societal complexity."

[5] A society's collective learning may be determined by 1) how the belief system "filters" or

interprets information gained from experience and/or 2) different experiences that confronted

people at different times.

[6] Institutions affect the acquisition of "pure" knowledge, or existential truth, through

scientific research.

[7] We as human beings have learned how to progress economically over time, but explaining

1) why "material well-being" is the exception rather than the rule and 2) the "pace and

direction of economic change throughout history" has proved to be quite difficult.

[8] If we represent the human experience as a 24-hour clock, "civilization" occurs around 23:56.

[9] If the last 10,000 years are represented as a 24-hour clock, modern economic growth and its

accompanying population explosion begin at about 23:25. Furthermore, most of this growth

took place in Western Europe, Britain and their overseas extensions.

[10] Over time, the pace of economic growth has varied and change has not necessarily moved

in one linear direction.

Section VI: Implications of the institutional/cognitive approach for improving our

understanding of the past

[1] The institutional/cognitive approach to understanding economic history helps us understand

that the conditions for economic growth don't automatically evolve. Growth depends on

cooperation between political and economic institutions that facilitate low-cost transactions in

impersonal markets.

[2] When thinking about changes that took place in Europe from the "dark ages" to the

"enlightenment", we're just beginning to understand the historical process of how "a gradually

evolving belief system in the context of competition among fragmented political/economic

units producing economic institutions and political structure" led to modern economic growth.

[3] Institutional/cognitive analysis helps explain "path dependence", but should not include a

classical assumption of rationality. This is because economies grow, contract and stagnate due

to politics and belief systems - the behavior and outcomes of which are difficult, if not

impossible to predict.

[4] The institutional/cognitive analysis should be integrated with studies of demography and

technological change so we can better understand economic history.

Section VII: Implications for current development policies

[1] We should take an institutional/cognitive approach to development problems, which will

help provide us with a new analytical framework.

[2] Formal rules, informal norms and enforcement characteristics shape economic

performance. The rules may change quickly, but the rules are only legitimized by the informal

norms - which may only change gradually.

[3] We know that groups of people, or polities, determine economic performance based on

their creation and enforcement of rules, but we don't yet know how to create or transfer

effective policy for economic growth to the "developing" world. Yet, we do know that behavior

(i.e. informal norms) must change to support and legitimize new rules and that long-run growth

depends on the development of, amongst other things, the rule of law.

[4] We know that long-run growth depends on flexible institutions that foster adaptability to

change, but we don't know how to create "adaptive efficiency" in the short-run.

[5] We will be better able to understand economic change through time and help economic

theory deal effectively with new issues through an analytical framework that employs historical

evidence and institutional/cognitive analysis.