A Transaction Cost Approach to the Historical Development of Polities and Economies

Author(s): Douglass C. North

Source: Journal of Institutional and Theoretical Economics (JITE) / Zeitschrift für die
gesamte Staatswissenschaft , December 1989, Vol. 145, No. 4 (December 1989), pp. 661-
668
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 Journal of Institutional and Theoretical Economics (JITE) 145 (1989), 661 668
Zeitschrift für die gesamte Staatswissenschaft

A Transaction Cost Approach to the Historical

Development of Polities and Economies*

by

Douglass C. North

The differential performance of polities and economies over time is fundamen-

tally influenced by the way institutions evolve. We do not, however, have a
framework which allows us to integrate institutional analysis into political
economy. The key to developing such an analytical framework is, I believe, the
underlying costs of exchange. The transaction cost literature has focused on
economic exchange and the institutions that shape those costs. In this essay I
wish therefore to extend the transaction cost approach to political exchange
and to explore the interaction of political and economic institutions in the
development of polities and economies. I begin by describing the basic charac-
teristics of political and economic rules. I then elaborate a transaction cost
approach to political rules and the implications of the consequent political rules
for economic rule formation. The final section analyzes the nature of political
and economic institutional change and the way that institutional change shapes
the historical performance of economies.

//

Political rules broadly specify the hierarchical structure of the polity, its basic
decision rules, and the explicit characteristics of agenda control. Economic
rules define property rights, that is the bundle of rights over the use and the
income to be derived from property and over the ability to alienate an asset or
a resource. Contracts contain the provisions specific to a particular agreement
in exchange.
Given the initial bargaining strength of the decision-making parties, the
function of rules is to facilitate exchange, political or economic. Politics con-
cerns bargaining over the structure of the society and the economy. Specifically
the bargains are about rights. The existing structure of rights (and the character

* This essay is a drawn from, and a condensation of, part of a forthcoming book by
the author entitled Institutions, Institutional Change, and Economic Performance.

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 662 Douglass C. North JJDTTIE

of their enforcement) defines the existing

the players which can be realized by for
exchanges. Such bargains are made within
equally the players at times find it worth
the more basic structure of the polity reas
The extent of economic and political diver
bargaining strength) influence the rules' s
more numerous the interests, the less likel
will obtain and the more likely instituti
complex forms of exchange (partly forma
ways of solving problems by coalition f
however, as Madison did so eloquently in
United States Constitutional structure was devised in 1787 to facilitate certain
kinds of exchange and to raise the costs of those kinds of exchange which
promote the interests of "factions". So it is in economic exchanges. Patent laws
and trade secret laws are designed to raise the costs of certain kinds of ex-
change.
Rules are devised with compliance costs in mind, which means that methods
must be devised to ascertain that a rule has been violated, to measure the extent
of the violation (and consequent damages to the party to exchange), and to
apprehend the violator. The costs of compliance include those of measuring the
multiple attributes of the goods or services being exchanged or of the perfor-
mance of agents. In many cases, the costs of measurement (given the technology
of the time) exceed the gains, and rules are not worth devising and ownership
rights are not delineated (common pool problems). Changes in relative prices
will alter the relative gains from devising rules.

///

Broadly speaking, political rules in place lead to economic rules, though the
causality runs both ways. That is, property rights and hence individual con-
tracts are specified and enforced by political decision-making even though the
structure of economic interests will also influence the political structure. In
equilibrium a given structure of property rights (and their enforcement) will be
consistent with a particular set of political rules (and their enforcement).
Changes in one will induce changes in the other. But because of the priority of
political rules, we begin our analysis with the structure of the political system
and explore the nature of the gains from trade, the transaction costs and the
consequent institutions in successively more complex polities.
Let me start with a simplified model of a polity made up of a ruler and
"constituents".1 In such a simple setting, the ruler acts like a discriminating
monopolist, offering to different groups of constituents "protection and jus-

1 This simple model is developed in much more detail in Chapter 3, "A Neo-classical
Theory of the State", in North [1981].

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145/4 (1989) Historical Development of Polities and Economies 663

tice" or at least the reduction of internal disorder and the protection of property
rights in return for tax revenue. Since different constituent groups have differ-
ent opportunity costs and bargaining power with the ruler, different bargains
result. But there are also economies of scale in the provision of these (semi-pub-
lic) goods of law and enforcement. Hence, total revenue is increased, but the
divison of incremental gains between ruler and constituents depends on their
relative bargaining power; changes at the margin, either the violence potential
of the ruler or the opportunity costs of the constituent, will result in redivisions
of the incremental revenue. Moreover, the ruler's gross and net revenue differ
significantly, as a result of the necessity of developing agents (a bureaucracy)
to monitor, meter, and collect the revenue. All the consequences inherent to
agency theory obtain here.
This model of the polity becomes one step more complicated when I intro-
duce the concept of a representative body reflecting the interests of constituent
groups and their role in bargaining with the ruler. This concept is consistent
with the origin of Parliaments, Estates Generales, and Cortes in early modern
Europe and reflects the needs of the ruler to obtain agreements to get more
revenue in exchange for the provision of certain services to constituent groups.
The representative body facilitates exchange between the parties. On the ruler's
side, this leads to the development of an hierarchical structure of agents, which
is a major transformation from the simple (if extensive) management of the
King's household and estates to a bureaucracy monitoring the wealth and/or
income of the King's constituents.
When we move from the historical character of representation in early mod-
ern Europe to modern representative democracy, our story is complicated by
the development of multiple interest groups and by a much more complicated
institutional structure devised to facilitate (again given relative bargaining
strength) the exchange between interest groups.2 This political structure reflects
concentrations of voters with specific interests in particular locations. Thus in
the United States polity, there are elderly in Florida and Arizona, miners in
Pennsylvania and West Virginia, artichoke growers in California, automobile
manufacturers in Michigan, etc. Because there are multiple interest groups and
these interest groups are reflected by legislators who have a concentration of
only a few interest groups in their districts, no particular interest group that a

2 The development of political theory in the last twenty-five years has paralleled
developments in economic theory. The developments began in an a-institutional setting,
in which the model was one that paralleled the a-institutional model of economics. But
the result, in terms of the formal theory, was that no stable equilibrium would evolve and
that "cycling" would be a continuous pattern of political systems (at least in 2 party, non
ideological models). However, this formal finding was at odds with empirical and descrip-
tive studies that provided no evidence of such dis-equilibrating characteristics, and it
remained to take a further step in political theory to explore the nature of the institutional
structure that provided for the evolution of equilibrium states in the political system. For
a description of this evolution and a model of structure-induced equilibrium, see Ken-
neth Shepsle [1983].

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 664 Douglass C. North JOTITE

legislator may represent can form a major

succeed acting alone, but must make agreem
different interests.
What kind of institutions will evolve fro
tween legislators reflecting multiple interes
with Buchanan and Tullock [1962], focu
rolling. While a step forward in recognizin
strike bargains that facilitate exchange, suc
fundamental problems involved in legislati
and payoffs were known in advance, and it
in fact a variety of exchanges arise in w
enacted by commitments made for a future
exchange, one had to devise a set of inst
allow for exchange over space and time.
exchange. In each case the problem is to m
rights.
How does credible commitment envolve to enable agreements to be reached
when the payoffs are in the future and on completely different issues? Self-en-
forcement is important in such exchange and in repeat dealings a reputation is
a valuable asset. But as in economic exchange, the costs of measurement and
enforcement, discovering who is cheating whom, when free-riding will occur,
and who should bear the cost of punishing "defectors" make self-enforcement
ineffective in many situations. Hence political institutions constitute ex-ante
agreements about cooperation among politicians. They reduce uncertainty by
creating a stable structure of exchange. The result is a complicated system of
committee structure, consisting of both formal rules and informal methods of
organization. Its evolution in the American Congress is described in a recent
study of the structure by Barry Weingast and William Marshall [1988],
entitled "The Industrial Organization of Congress". In the conclusion of their
essay, Weingast and Marshall [1988, 157] specify the kind of structure that
evolved :

Instead of trading votes, legislators exchanged special rights affording the holder of
these rights additional influence over well-defined policy jurisdictions. The influence
stems from the property rights established over the agenda mechanisms, that is the means
by which alternatives arise for votes. The extra influence over particular policies institu-
tionalizes a specific pattern of trades. When the holders of seats on committees are
precisely those individuals who had bid for votes on these issues in a market for votes,
policy choice under the committee system parallels that under a more explicit exchange
system. Because the exchange is institutionalized, it need not be renegotiated each new
legislative session, and it is subject to fewer enforcement problems.

IV

The property rights structure that is developed within the framework of a polity
will reflect the relative bargaining strength of the parties. Since I have analyzed

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145/4 (1989) Historical Development of Polities and Economies 665

property rights formation in previous studies (North and Thomas [1973], and
North [1981]), I will not repeat the analysis except to restate and then amplify
the point (North [1981]), that the result will typically be "inefficient" property
rights.3 These inefficiencies arise because the set of rules that develop will
typically have to take into account, in a maximizing world, the transaction cost
and competitive constraints on the parties. The transaction costs constraints
will reflect the fact that monitoring, metering, and collecting taxes may very
well lead to a situation in which less efficient property rights will be devised,
because they result in more tax revenue than do more efficient property rights.
The competitive constraint will reflect the phenomenon that frequently it would
not be in the interest of members of the polity to produce efficient property
rights, because that would antagonize powerful groups of constituents and
would lead to the overthrow of the existing polity. Both sets of constraints have
typically resulted in property rights that were not conducive to long-run eco-
nomic growth. However, this argument elaborated in my earlier study, requires
amplification.
As a first approximation property rights will be developed over resources and
assets as a simple cost-benefit calculus of the costs of devising and enforcing
such rights, as compared to the alternatives under the status quo. Changes in
relative prices or relative scarcities of any kind lead to the creation of property
rights when it becomes worthwhile to incur the costs of devising such rights.
This simple model has indeed been the basis for a substantial amount of the
property rights literature, which looks on the development of property rights
as a simple function of changes in costs and benefits. But it should be noted that
the story is in fact more complicated than this. Such a story leaves out the
incremental process by which institutions change; the naive model therefore
must be replaced by a more complicated one. The simple model of the evolution
of property rights would be consistent with Axelrod's [1984] story of the
evolution of cooperation; but in fact we do not always observe such an evolu-
tion, as both history and persistence of poverty and lack of development in the
third world attest.
What is missing is a more complex study of the way by which the polity
evolves and how that translates into the kind of property rights that will be
specified and enforced. Not only may the evolving political institutions spawn
property rights that do not induce economic growth but also the consequent
organizations may have no incentive to create more productive economic rules.
At issue is the incremental character of institutional change as well as the
problem of devising institutions that can provide credible commitment so that
more efficient bargains can be struck. I now explore institutional change as a
preliminary to showing how such inefficient paths of change can persist
through time.

3 The term inefficiency here is simply meant to specify the development of a set of
constraints that will not lead to economic growth.

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 666 Douglass C. North JJfflTIE

In order to understand institutional change one must first understand just what
it is about institutions that makes for stability. This condition is accomplished
by the complexity of the set of constraints that constitute institutions; by rules
nested in a hierarchy, each level more costly to change than the previous one.
Informal constraints that are extensions, modifications and qualifications of
formal rules are even more important anchors of stability because they "solve"
numerous exchange problems not completely covered by formal rules. They
allow people to go about the everyday process of making exchanges without the
necessity of thinking out exactly at each point and in each instance the terms
of exchange. Routines, customs, traditions, and culture are words we use to
denote the persistence of informal constraints. It is the complex interaction of
rules and informal constraints, together with the way they are enforced, that
shapes our daily lives. However it is important to stress that these stability
features in no way guarantee that the institutions are efficient (as defined
above). Stability is a necessary condition for complex human interaction but it
is not a sufficient condition for efficiency. Efficiency would entail both stability
conditions and institutions that provide incentives for organizations to become
more productive (to be discussed below).
Institutions do change. One major source of institutional change has been
changes in relative prices (see North and Thomas [1973] for illustrations) but
another has been changes in preferences. I know of no way to explain the
demise of slavery in the 19th century in an interest group model. The growing
abhorrence on the part of civilized human beings of one person owning another
not only spawned the anti-slavery movements but through the institutional
mechanism of voting resulted in the elimination of slavery. The voter paid only
the price of going to the polls to express his conviction and the slave owner had
no feasible way to bribe or pay off voters to prevent them from expressing their
beliefs. Institutions make ideas matter.
The agent of change is the entrepreneur - political or economic. So far I have
left organizations and their entrepreneurs out of the analysis and the definition
of institutions has focused on the rules of the game rather than the players. Left
out was the purposive activity of human beings to achieve objectives which in
turn result in altering constraints. Organizations and the way they evolve alter
outcomes, but how?
The institutional constraints together with the traditional constraints of
economic theory define the potential wealth maximizing opportunities of en-
trepreneurs (political or economic). If the constraints result in the highest
payoffs in the economy being criminal activity, or the payoff to the firm is

4 Yet paths do get reversed as the recent history of Argentina (from productive to
redistributive) or Spain (the reverse) illustrate. Partly reversal can be explained by the
unanticipated consequences of entrepreneurial activities. But there is more to path rever-
sal than that as the recent turmoil in stagnant socialist economies attest. Ideas and

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145/4 (1989) Historical Development of Polities and Economies 667

highest from sabotaging or burning down a competitor, or to a union from

engaging in slowdowns and makework, then we can expect that the organiza-
tion will be shaped to maximize at those margins. On the other hand if the
payoffs come from productivity enhancing activities then economic growth will
result. In either case the entrepreneur and his or her organization will invest in
acquiring knowledge, coordination and "learning by doing" skills in order to
enhance the profitable potential. As the organization evolves to capture the
potential returns it will gradually alter the institutional constraints themselves.
It will do so either indirectly, via the interaction between maximizing behavior
and its effect on gradually eroding or modifying informal constraints; or direct-
ly, via investing in altering formal rules.
In either case the change is an incremental process; the result of thousands
of individual decisions by organizations and their entrepreneurs which cumula-
tively are altering the institutional framework over time. Thus short run prof-
itable opportunities cumulatively create the long run path of change. The long
run consequences are often unintended for two reasons. First, the entrepreneurs
are seldom interested in the larger (and external to them) consequences but the
direction of their investment influences the extent to which there is investment
in adding to or disseminating the stock of knowledge, encouraging or discour-
aging factor mobility, etc. Second, there frequently is a significant difference
between intended outcomes and actual outcomes. Outcomes frequently diverge
from intentions because of the limited capabilities of individuals and the com-
plexity of the problems to be solved.
The path of institutional change that determines the long run evolution of
economies is shaped by constraints derived from the past and the (sometimes
unanticipated) consequences of the innumerable incremental choices of en-
trepreneurs which continually modify those constraints. Path dependence
means that history matters, that it is a consequence of incremental change and
that it can account for the divergent paths of economies.
Now given the tendency of polities to produce inefficient property rights,
economic decline or stagnation can persist since there will not typically develop
a feedback that will create organizations with the incentive to invest in produc-
tive activity. That is, the organizations that are created by a set of property
rights that reward redistributive rather than productive activity, will become
more efficient at such activities and will foster political organizations with
similar objectives. The overall institutional matrix will always be a "mixed bag"
including some organizations that will promote productive activity, but if
redistributive organizations predominate the polity will have evolved an institu-
tional structure to facilitate those particular type of exchanges. Such a path is
hard to reverse, as Latin American economic history will attest.4 Indeed the

ideologies matter, but we are still a long way from devising models of the polity that can
take into account the complex interplay of interest group action with the way ideas
modify or shape the resultant choice set of the players.

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 668 Douglass C. North JJIME

persistence of "inefficient" paths is far mo

than are paths of economic growth. A tra
economic institutions offers the promise
differential performance of polities and e

References

Axelrod, Robert [1984], The Evolution of Cooperation, New York: Basic Books.
Buchanan, James M. and Gordon Tullock [1962], The Calculus of Consent, Ann
Arbor: University of Michigan Press.
North, Douglass C. [1981], Structure and Change in Economic History, New York:
Norton.
-- and Robert P. Thomas [1973], The Rise of the Western World: A New Economic
History, Cambridge: Cambridge University Press.
Shepsle, Kenneth A. [1983], Institutional Equilibrium and Equilibrium Institutions,
51-81, in: Herbert Weisberg (ed.), Political Science: The Science of Politics, New
York: Agathon Press.
Weingast, Barry w. and William Marshall [1988], The Industrial Organization of
Congress; Or, Why Legislatures, Like Firms, Are Not Organized As Markets,"
Journal of Political Economy, 96, 132-163.

Douglass C. North
Luce Professor of Law and Liberty
and
Director, The Center in Political Economy
Washington University
Campus Box 1208
St. Louis, Missouri 63Í30
U.S.A.

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