In the first post of the series on Understanding the Process of Economic Change, I presented Douglass North’s view on the effect of the stock of knowledge. This post reviews his insights into how institutions affect the evolution of economies. The entire review will be available on Dianoetic in the near future.
Douglass North, a Nobel Prize laureate, is a New Institutional Economist. No wonder why he devotes a large portion of the book to institutions and their role in the process of economic change. To briefly present his ideas on this matter, here I start with the definitions. I also clarify the important distinction between institutions and organisations.
As I discussed in the previous post, uncertainties are always present in humans’ knowledge and in their interactions with each other and with the world in general. The uncertainties and the impossibility of attaining a perfect knowledge leave a gap between an agent’s competence and the decisions she makes (Heiner 1983). Thus, in confronting the world, she builds constraints to restrict the flexibility of the choices. Those constraints, built due to human intentionality, are institutions.
“Institutions are the rules of the game, organizations are the players; it is the interaction between the two that shapes institutional change.” (p. 59)
The institutional matrix together with general economic constraints determine the opportunities available to the agents. They also determine the type of organisations that are born and grown in the economy. Vigorous competition among those organisations, in turn, produce rapid institutional change.
As I mentioned in the previous post, the reality of the world is not (and will never be) known to us. However, to be able to perform, we construct belief systems about the world, which are both positive and normative. In other words, our belief systems try to tell us how the (economic) world works and how it should work.
The belief systems are not rigid, no matter how much they may seem. Our interactions and experience with the world provide feedback to our belief systems, leading to their eventual modification and development.
The entire process can be summarised in this way: we have a perception of the reality of the world and human interactions. We build a system of beliefs according to the perceived reality. We construct institutions to constrain our interactions on the foundation provided by our belief systems. These constraints lead to policies. These policies, in turn, alter and shape our perception of the reality. I schematically demonstrate this process in Figure 1.
The schematic of the process has an important message: the relation between the stock of knowledge and institutions is not one-way but they mutually modify each other. We construct institutions based on our knowledge and perception of reality. However, the currently established institutions determine what information we absorb in our belief system. In other words, the institutional structure dictates the choice of adopted knowledge.
To progress and prosper, we impose institutional change by altering and manipulating the structures of social interactions. However, the result is not always in line with the intentions, and consequently, much of economic change has been the unwanted outcome of institutional change. The unintentional results are symptoms of “faulty” belief systems.
The institutional matrix play a twofold role in poorly performing economies:
- It creates organisations with benefits in the existing structure. They resist economic and institutional change.
- It does not support efficient support for combining dispersed knowledge necessary for improving economic activities.
I conclude this post with important propositions about how institutions, themselves, change:
- The continuous interaction between institutions and organizations in the economic setting of scarcity and hence competition is the key to institutional change.
- Competition forces organizations to continually invest in skills and knowledge to survive. The kinds of skills and knowledge individuals and their organizations acquire will shape evolving perceptions about opportunities and hence choices that will incrementally alter institutions.
- The institutional framework provides the incentives that dictate the kinds of skills and knowledge perceived to have the maximum pay-off.
- Perceptions are derived from the mental constructs of the players.
- The economies of scope, complementarities, and network externalities of an institutional matrix make institutional change overwhelmingly incremental and path dependent.” (p. 59)
Heiner, R. A. (1983). “The Origin of Predictable Behavior.” American Economic Review 83: 560-595.
North, D. C. (2005). Understanding the process of economic change. New Jersey, Princeton University Press.