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Douglass North - Structure And Change In

Economic History (Book Summary)

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Micahyas  Akama  
 
Douglass North - Structure And Change In Economic History
(Book Analysis)
Neo-classical economics is a theory whereby the value of the market supersedes
the importance of institutions and historical processes in economic growth. North
describes the neo- classical model as not having “organizations and institutions except for
the market.” (1981, 10) However, this model has ignored one inherent human character
that will challenge it- the free rider dilemma. Within the assumptions of the neo-classical
economic model, an individual would not take initiative to effect any possible changes in
institutional rules. Rather, that individual would let others incur the costs of change and
draw its benefits. Therefore, in a neo-classical world, the free rider dilemma would lead
to static institutions and perhaps very slow social/institutional evolution. North
consistently makes it clear, however, that a neo-classical world is a theoretical framework
of understanding economics and that it is futile in our modern democratic society. He
stresses that “a neoclassical world would be a jungle and no society is viable.”(North
1981, 11) Nonetheless, he continues to use this framework to understand and explain the
self-regulating market and how markets adjust in different conditions.
North’s argument against neo-classical economics is that it does not resemble
economic reality. North acknowledges the role of the market and its compelling influence
on the producer and consumer. In reality, the market alone does not constitute the whole
of economic transactions and processes. Instead, regulatory bodies or institutions lay out
a framework of constraints within which economic transactions and processes are to be in
practice. These institutions, according to North, provide stability by reducing uncertainty
and unpredictability of behavior through well-defined ground rules. In North’s words,
“the rules and regulations define the terms of exchange … between principals and
principals and agents.” (1981, 18)
North makes an interesting claim as it pertains the relationship of the free rider
dilemma and ideology. He argues that compliance cost is enormous without the
willingness of individual restraints from self-maximizing behaviors. He concludes that
individuals do not always choose self-maximizing behaviors, which calls into question
the extent to which the free rider dilemma applies in a neo-classical world. North
proceeds to bridge the vacuum between individual restraint and the free rider dilemma
through the role of ideology on human behavior.
Neo-classical economics would argue to eliminate price control. In Chapter 3,
North goes on to present a counter force against the neo-classical economic theory- a
neo-classical theory of the state. North divides the state in two systems, contract and
predatory. The crucial differences between the two is that the contract system favors the
state as a primary actors for maximizing the wealth of society while the predatory system
tends to have a Marxist view in that a small-elite group or class extract the wealth of the
society for the benefit of those who constitute the group. (North 1981, 22) The elite group
in the predatory system, in my interpretation, is comparative to what Manure Olson calls
“stationary bandits.”
North makes a plausible argument that the state is an essential tool for not only
stability, but also economic growth. North finds economic growth as being embedded in
a robust and evolving framework of rules. Within the confines of this framework is where
structure of economic relationships can form with little transaction costs and instability.
He assures the need for the state for economic development. North states, “the creation of
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the sate in the millennia following The First Economic Revolution was the necessary
condition for subsequent economic development.”(1981, 24) The main arguments for a
state as the tool for economic growth are that the state reduces transaction costs (i.e.
standardization, enforcing contracts), and sets the rules of cooperation and competition.
Another interesting but questionable argument put forth by North is the free rider
dilemma as an agent of stability for the state. In regards to this assessment, North claims
that because of the free rider problem, individuals do not oppose the coercive forces of
the state or act as classes or groups to overthrow the state. (1981, 32) North also
proceeds to make the claim that due to the free rider dilemma, institutions will continue
to serve the interests of the ruler. (North 1981, 32)

The First and Second Economic Revolutions:

Many would argue that the transition of humans from a hunting and gathering
system to settled agriculture sparked a significant era of change in human economic
activities, and as Douglass North describes, it became “The First Economic Revolution.”
The transition to settled agriculture was especially significant as it paved the path towards
an increase in the resource base. The impact of this transition, as archeologist V. Gordon
Childe argues is that it accelerated the “process of learning” towards increasing the
resource base despite biological constraints. (North 1981, 73)
Because of the absence of a market, the value of goods and services were
contingent upon the marginal product of labor. In other words, goods and services were
allocated according to the value of the scarce labor employed to produce them.
Reevaluating the transition from hunting and gathering to settled agriculture within this
context would then suggest that the marginal product of labor resulted in less productivity
in a hunting and gathering system than it did in settled agriculture. The output in settled
agriculture then was higher than it was in a hunting and gathering system.
In the face of declining resource base to the extent of the extinction of animals,
the need for greater control of resources became a question of survival. In a hunting and
gathering system, resources were held as a common property. This means that the
resource base was virtually open to anyone wishing to exploit it; there was no designated
ownership of the resource base. As economists would widely argue, unconstrained
resource base leads to its inefficient utilization leading to the depletion of the resource
base. (North 1981, 80)
Individuals act in self-maximizing behaviors. In a common property where
resources are open to anyone, Individuals would turn to self-maximizing behaviors; that
is, to the extent of their capability, exploit the common resource to their benefit. This in
turn would lead to the extinction of the stock itself. If all individuals act in self-
maximizing behavior, rational choice theory would forecast that the society would also
be a reflection of the individual behavior. This present an imminent danger to the
resource base and therefore a barrier to prevent exploitation of the resource base is
necessary.
The barrier that was required to prevent the exploitation of resources became
known as property rights. The origin of this principle could be traced back to communal
rights in agriculture. In a hunting and gathering system, on the other hand, there existed
common property rights. (North 1981, 82) North argues that the development of
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technological advances was fueled by the incentives provided by communal property
rights. Therefore, this argument implies that economic and technological development
was, in essence, the result of exclusive property rights, which provided incentives for
efficiency and productivity. (North 1981, 89)
The “first economic revolution” also contributed to the emergence of social and
economic organizations or institutions. As I have mentioned above, property rights
specified labor with incentives and excluded those from benefiting from the output
generated by others. Settled agriculture created the division of labor whereby specialized
occupations emerged. This in turn created institutions as mechanisms for distributing the
community output among the population. (North 1981, 94) These institutions were able
to organize tasks for more efficient productivity. However, as populations grew, the
incentive to be a free rider increased requiring the establishment of the state.
With the emergence of the state, institutions intensified. Organization for
distributing outputs reduced transaction costs. States also began to compete with other
states which led to economic expansion and widening of the markets. The most important
power of the state was its coercive capabilities used to enforce the rules of its internal
structure. Later, the Egyptians introduced taxation, the Persians introduced decentralized
governance, and the Greeks introduced citizens and citizens’ role in the states’ decision-
making process. All of these new undertakings were the effect of the “first economic
revolution”.
The Second Economic Revolution was simply, as defined by North, “the wedding
of science and technology.” (North 1981, 159) But, what does this mean? In other words,
The Second Economic Revolution was the wedding of knowledge and technological
development. The Industrial Revolution accelerated the rate on innovation that expanded
the market size, resulting in an increase in transaction costs because of specialization and
division of labor. To remedy transaction costs, organizational changes and better-
specified property rights were devised, and as mentioned above, this led to an increase in
the private rate of return. Regarding the definition of The Second Economic Revolution
as the context in which to understand the Industrial Revolution, North proceeds to
conclude that the Industrial Revolution wasn’t a “revolution” after all; at least in
comparison to the last half of the nineteenth century. (North 1981, 162) Rather, North
argues that the Industrial Revolution was “the evolutionary culmination of a series of
prior events.” (North 1981, 162)
North stress that science is the foundation of “basic knowledge” onto which
humans build on for technological advancement. Precisely because of the absence of such
basic knowledge, great technological strides were not achieved during the Industrial
Revolution. Indeed, North agrees that technological change manifested during the
Industrial Revolution, however it was a cause of “learning by doing” rather than complex
scientific experimentations. (North, 1981, 162) North gives as a hypothesis for his
subsequent argument. He concludes that the social rate of return for technological
advancement has always been high and assumes that unless the private rate of return is
also high, there would be a slow progress of technological change. (North 1981, 164)
North plausibly argues that the slow technological change in human history was
due to the lack of systematic property rights on innovation. What does this mean?
Historically, there have not been sanctions (Institutionalized) for those who exploit the
inventions of others. Similarly, the private rate of return on innovations and inventions
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was low. It was only in 1624, through the Statue of Monopolies that patent law emerged
in Britain. Essentially, patent law gave innovators and inventors’ exclusive property
rights and attached value to those property rights. The cyclical argument that North
makes is that raising the private rate of return is significant for technological change as
observed in the latter half of the nineteenth century. Aside from increased private
benefits, the expansion of market sizes makes it conducive for technological change as
well.
North concludes that the Industrial Revolution was initiated by the increasing size
of markets. In part, this resulted in economic organizational changes towards
specialization. And because specialization must result in a uniform output, inputs needed
to be supervised and hence, transaction costs increased. Nonetheless, because inputs were
supervised intimately, quality improved which in turn lowered the cost of devising new
techniques for newer products/services. In fact, “the Industrial Revolution came about as
a result of organizational changes to improve the monitoring of workers.” (North 1981,
169) In sum, specialization brought organizational innovations resulting in technical
changes that led to further organizational innovations. (North 1981, 169)
The impact of The First and Second Economic Revolutions are best understood in
North’s own words. He writes as follows:
“Both economic revolutions deserve the tittle because they altered the slope of the
long-run supply curve of output so as to permit continuing population growth
without the dismal consequences of classical economic model. The First
Economic revolution created agriculture and civilization; the second created an
elastic supply curve of new knowledge, which built economic growth into the
system. Both entailed substantial economic reorganization.” (North 1981, 171)

Despite the positive impact of The Second Economic Revolution, it did not fail to raise
many criticisms. One of the most common criticisms is from Karl Marx and Karl Polyani
who argue that the impact of The Second Economic Revolution has a negative impact on
workers (Marx) and the social fabric of society (Polyani) due to the impersonal nature of
the market. Nonetheless, both of the economic revolutions have transformed the history
of human economic trajectory.

Conclusion:

The First and the Second Economic Revolutions altered the economic dynamics
of human history. As population grew, theories such as that put forth by Thomas Malthus
emerged and stated that output, in the near future, would not be able to keep up with the
high rate of population growth. Essentially, The First and Second Economic Revolutions
disproved this theory. The transition from a hunter-gatherer system to agriculture brought
surplus that was able to sustain a certain rate of population growth. This First economic
revolution, in essence, increased the resource base and transitioned from common
properties to communal property rights. As this transition rendered the efficient use of the
resource base, property rights created incentives for innovation and invention. How did
property rights incentivize innovation and invention? The Second Economic Revolution
answers this precise question. This Economic Revolution also dealt with property rights
but differently and in a different era. The core of The Second Economic Revolution was
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the Industrial Revolution; and because of the development of property rights in The First
Economic Revolution, private rate of return increased on innovation and invention, which
incentivized technological advancement. (North 1981, 147)

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