Online library entry
North D. (2003) The Role of Institutions in Economic Development, Discussion Paper 2003.2. UN Economic Commission for Europe, Geneva.
Douglas North is often credited with being the father of New Institutionalism in economics. Institutionalist scholars seek to explain differences in market performance and overall economic development in terms of differences in the institutional framework within which markets operate.
North’s primary contribution is the observation that the neoclassical economist’s vision of market exchange as frictionless and static or timeless is unrealistic; we cannot adequately understand markets by accepting the assumptions of fully informed, rational actors making choices in similar ways while responding to the same fundamental structural constraints. Rather, North counters that there are considerable “transaction costs” or costs associated with conducting market exchange. The level of these transaction costs is determined, in turn, by the institutional context within which markets operate. North refers to institutions as “the incentive systems that structure human interaction;” they are necessary to make predictable our everyday business dealings with each other and to ensure we reach effective solutions to problems.
Institutions are made up of formal rules, informal constraints and their enforcement characteristics. They vary in form across time and space as does their enforcement. This variation then helps explain differences in economic performance between countries. This then raises the crucial question of how societies can develop the institutions required—in North’s view—for complex markets to function effectively. In particular, markets require effective third party enforcers, a state with a judiciary, but achieving this is a challenge.
In this piece — contrary to some of his earlier writing — North argues there is no ‘best practice’ to follow in pursuing formal institutional reform. Rather, reformers have to be conscious of how formal rules will interact with different informal norms and enforcement characteristics across societies. At the same time, they must learn to navigate political obstacles on the ground. The answer for reformers is to aim for “adaptive efficiency”, namely flexible institutions that provide a maximum of choices at a given moment in time. The end goal may be the same—i.e. achieve an institutional framework that functions to supports market efficiency—but the paths to achieving this goal will vary.