This article looks at how North applies neoclassical principles to his work about institutions as constraints, while at the same time arguing that people and organizations can change the constraints that within institutions. My notes here are about the points that interest me, they don’t reflect a full summary of the article.
- Defining institutions, transaction costs, and property rights
- Neoclassical assumptions and their critique
- Neoclassical economics as non-institutional
- Rationality, cognitive constraints, and ideology
- Free riding, opportunism, and legitimacy
- The relative importance of relative prices
- Efficiency and evolution
- History versus historical
- A shifting emphasis
Within economic theory, an institution governs the relationship between organizations, people and organizations, or between people. North’s definition is broader than most economists because he includes ‘inter- and intra-organisational issues of private transacting…. [and] the cultural, social, and cognitive processes which provide a norm structure and thus also guide human interaction’ (Vandenberg, 2002, p. 219).
There are two similar terms:
- Transformation costs are the production costs (capital, labor, material, etc.).
- Transaction costs are the ‘costs of specifying what is being exchanged and enforcing the subsequent agreement’ (Vandenberg, 2002, p. 220).
Organizations apply utility maximization — that is, they try to get the greatest value for the least cost. According to North, they do this ‘within a framework of institutional cooperation to reduce transaction costs, and secure property’ (Vandenberg, 2002, p. 222). Transaction costs have two parts (specification and enforcement) and institutions (laws and norms) lower each part of the transaction costs:
- Specification: This is the process of measuring the item that is being bought, sold, or traded. Sometimes specification is supported by government measures: ‘the state can play an important role in reducing these specification costs through credible systems of weights and measures. At a developed level, the activities involve grading… and inspection’ (Vandenberg, 2002, p. 220).
- Enforcement: There are a set of constraints that are usually either informal norms (among a small group of people who know each other) or formal laws (among a larger group of people), and these are enforced either legally or through the relationships. Enforcement lowers the transaction cost because it makes sure that people deal honestly.
Change, transaction costs, and efficiency
Change happens ‘[t]hrough periods of prosperity and stagnation, based on efficiency of institutions in lowering transaction costs and securing property rights’ (Vandenberg, 2002, p. 222).
Ideally, better and more efficient institutions would replace inefficient ones. This doesn’t always happen, though. For example, political leaders may establish laws (institutions) that make the markets less efficient by providing advantages to their supporters. In this example, the institutions are beneficial to the supporters and thus to the leader, but are economically less efficient.
Rationality and mental models
Organizations and people make rational decisions, but it is bounded rationality — rational decisions (purposeful decisions made by considering possible outcomes) is limited because we lack complete information.
But how much are decisions limited by incomplete information, and how much are they limited by habit and culture? A person’s conduct, including decisions about whether to follow rules, depends on their ideology or mental models. They give you a sense of what’s right, and so they help you economize how much information you need to make a decision. Mental models can be highly subjective; decisions made primarily on the basis of mental models are not necessarily rational.
North’s sports analogy was that institutions are the rules of the game, and organizations are the players. One way organizations respond to institutions is to “cheat” in the game. This can be not participating in the efforts but taking part in the benefits, or engaging in fraud, or withholding information from other trading partners.
However, there are times when organizations would benefit from free-riding or other cheating, but they don’t do it. North thinks this is sometimes based on a moral code or altruism, which means not all actions by organizations are based on self-interest.