Transaction Costs, Institutions,

and Economic History

Douglass C. North
 Introduction
• Ideas of neo-classical economics have been used to study economic
history since the cliometric revolution
• Body of literature related to resource allocation was built by
assuming zero transaction costs
• It also assumed the operation of perfect competitive market
• However, in reality, there are costs and uncertainties involved in
transactions
• North has proposed a new framework by integrating the positive
information costs, uncertainty and transaction costs to analyse the
changing structure of the economies (Economic History)
 Specialisation and Division of Labour
• Gains from trade is the bedrock of all the economic theories
• All economists propagated that the specialization and division of labour enhances
the productivity and growth of new technologies
• But according to North this is just a half theory as it ignores the costs of trade
• Costs of the trade is the losses that arise because of specialization and division
of labour
• Transaction costs are the costs of specifying and enforcing contracts that
underlie exchange and therefore comprise all the costs of political and economic
organization that permit economies to capture the gains from trade
• None measured these costs but as per examinations of North it may be 50
percent of the GNP of western countries. Grown substantially in last centruy
 Institutions, Principals and Agents
• Production and transaction costs have determined the output throughout the history
• That is why North argued to integrate theory of transaction costs with theory of
production to provide the essential framework for the economic historian
• Costs of transacting are shaped by structure of political and economic institutions
• Institutions are contractual arrangements between principals and agents, made to
maximize their wealth by realizing the gains from trade
• An agent gives up some control over his or her own decision-making to the principal.
• Therefore, principals are employers, managers, government officials
• Agents are workers, bureaucrats, college professors who work for chairmen, chairmen
who work for deans, etc.
• The contracts may be implicit or explicit.
• But whether implicit or explicit, they must be defined and enforced; and it is the costs of
defining and enforcing them that make up transaction costs.
 Institutions: Assumptions
• Institutions consist of a set of constraints on behavior in the form rules and regulations
• This institutional framework rests on three fundamental assumptions.
• First, an individualistic behavioral assumption
• Second, an assumption that specifying and enforcing the rules that underlie contracts is costly
• Third, an assumption that ideology modifies maximizing behavior

• The cornerstone of economic theory is the idea that individuals aim to maximize wealth
when unconstrained.
• Constraints, such as rules and institutions, enable human organization and civilization.
• However, it's important to understand that individual maximization underlies the theory
of institutions, where individuals may benefit from forming organizations but may also
seek to disobey rules if the cost of detecting such behavior is high.
• Consequently, many organizational challenges involve defining and enforcing rules that
individuals have an incentive to disobey.
 Institutions: Assumptions
• Second assumption: that it is extremely costly to specify and enforce the
contractual rules that underlie institution
• Exchange in standard theory assumed an instantaneous exchange of a uni-
dimensional good or service
• But in reality, goods and services have multiple valued attributes from which we
get utility;
• It is extremely costly to measure each attribute in contractual exchange and to
the degree that these attributes are measured imperfectly, the participants in
exchange have the opportunity to take advantage of each other.
• Therefore, what contracts attempt to do is to specify as precisely as possible the
valued attributes involved in the exchange process; but as long as some of those
are imperfectly measured, then the problems that we have described will
continual.
 Institutions: Assumptions
• If it is difficult to measure the valued attributes in exchange for goods
and services, the problems between principals and agents are even more
serious
• Principals try to maximize their gains from trade by constraining the
behavior of the agent
• If agent is not perfectly constrained then he may cheat, shirk, or
otherwise engage in activities which may be valuable to him but certainly
not valuable to the principal
• The problems of constraining the agents and the costliness of measuring
the output of the agent as per contract pose the fundamental dilemma of
agency and determine the shape of institutions dealing with hierarchy
 Institutions: Assumptions
• The costs of measurement constitute the first part of the total costliness of
contractual arrangements.
• Second are the costs of enforcing contractual arrangement
• If we had perfect measurement, with clear contract terms, and perfect
enforcement, contractual disputes would be easily resolved.
• However, enforcement is inherently imperfect due to the costs of
measuring contract fulfillment and the biases of those responsible for
enforcement, such as judges.
• Moreover, these enforcement officials can be influenced by their views
on the fairness of contracts, leading to potential contract abrogation if
they perceive a contract as unfair.
• This highlights how ideology plays a role in shaping a society's institutional
framework.
 Ideology and Institutions
• A comprehensive theory of institutions cannot disregard ideology because it
affects people's behavior and their perceptions of fairness in contracts and
institutions.
• Ideology simplifies complex information, but it also involves assessing the fairness
of these arrangements, making it essential to understand how individuals form
such views.
• Ideologies are shaped by people's experiences, and when experiences are
uniform, consensus ideologies emerge.
• These shared beliefs are found in tribal societies where common experiences
lead to collective beliefs and values.
• Conversely, divergent ideologies arise from diverse experiences, often due to
geographic or occupational specialization.
• Ideology operates on the same principles as gains from trade, as specialization
and division of labor drive both.
 Ideology, Institutions and Gains from Trade
• The implications for modeling institutions are evident: a society with a shared
ideological framework requires fewer formal rules and enforcement mechanisms,
while ideological diversity necessitates precise rule definitions and enhanced
enforcement due to conflicting interests.
• This diversity arises from the costliness of measuring performance and influences
the form of institutions.
• Gains from trade rely on contractual agreements forming the institutional
framework of a political/economic system.
• For economic organization to develop, some form of political order is essential, as
transaction costs can be prohibitively high without it.
• As specialization and economic complexity grow, capturing these gains becomes
more resource-intensive due to increased measurement and enforcement costs,
compounded by ideological differences among participants.
 Economic History- Agriculture Revolution
• North has provided an analytical framework to the economic history of the
western world
• According to him history is shaped by two fundamental revolutions
• The first was the development of agriculture, occurred in middle east ten
millennia ago and then developed independently other parts of the world
• Second was the industrial revolution happened in eighteenth century
• The first economic revolution produced settled agriculture, which necessitated a
much more complicated social and economic organization
• Property rights to exclude non-members and for the community defense.
• Agriculture also involves decisions like what to plant, when to plant, when to
harvest, store of goods (famine & drought), if irrigation was practiced then
coordinated integration and development of tasks and performance etc
 Economic History- Agriculture Revolution
• The institutions evolved out of decision making to make interaction simple
• The decision making was simple as there were emerging agricultural communities
and the size was small
• So, the cost of making such decisions were minimal.
• This would increase the agricultural productivity and reduce the consequences
arise from a crop failure and lead to increase in population
• Increase in population would increase the cost of decision making as well as cost
of coordinating production decisions and distributing the community product
• The result of all this was the creation of the state. To make rules and
enforcement.
• Rulers of the state can and have sometimes exploited individuals in their own
interest
 Economic History- Agriculture Revolution
• The state is an essential prerequisite for capturing the gains from
trade, but is also the source of exploitation.
• There were periods of sustained growth when the interests of the
ruler coincided with productivity increase
• Examples – Roman empire, Athens in 5th centrury, Rhodes in 4th and
3rd century, and Roman in first two centuries A.D.
• If the state is the necessary prerequisite for economic growth, it is
also the source of man-made economic decline. Ultimately, Athens
fell to Sparta; Rhodes was reduced by the competition and jealousy of
Rome; and the Roman Empire itself finally fell in the fifth century A.D.
 Economic History- Industrial Revolution
•
The second economic revolution was all about lots of new knowledge that helped us
make scientific and technological advances.
• It made things like neoclassical economics, which assumed we could keep growing,
possible.
• But it also meant we had to spend a lot more resources on doing business and made our
political and economic systems less stable.
• So, it had big impacts on how our economy and politics work.
• he second economic revolution involved large-scale production and distribution, driven
by specialization and division of labor.
• This led to increased exchanges in the production process, raising transaction costs.
• Despite the higher costs, the gains in productivity from specialization greatly improved
living standards and shaped the modern Western world.
 Economic History- Industrial Revolution
• The development during this period came with significant transaction
costs, evident in the changes from the late 19th century onwards.
• The U.S. labor force grew, particularly in white-collar jobs focused on
transactions.
• Additionally, the coordination and integration of production led to more
firms specializing in transactions, including finance, banking, insurance, and
government.
• These changes were driven by the need for quality control throughout the
production chain and the challenges of managing a workforce within this
new production system.
• Much of the new technology aimed to reduce transaction costs by
substituting capital for labor, limiting worker freedom, and automating
quality measurement.
 Economic History- Industrial Revolution
• The key problems included measuring inputs and outputs, determining
individual contributions, and resolving payment disputes.
• There were also unpriced outputs like waste and pollution, along with
complex costs associated with specifying desired properties for goods and
services at various production stages.
• The second economic revolution involved large, fixed capital investments
that required long-term contractual agreements.
• These contracts faced uncertainties about prices and costs, leading to
opportunities for opportunistic behavior during exchanges.
• This complexity resulted in substantial resources being devoted to
measuring and ensuring the quality of goods and services, often with
dissatisfactory outcomes.
 Economic History- Industrial Revolution
• The transition to team production led to economies of scale but also
increased issues of shirking.
• Employers implemented rules and incentives to maintain discipline, but
these were seen as inhumane by workers due to the lack of agreed-upon
measures for contract performance.
• Opportunistic behavior increased within and between firms, leading to
vertical and horizontal integration and the need for government
intervention to regulate contracts. Bureaucracy and deadweight losses
emerged as a result.
• The adoption of this technology also had unpriced benefits and costs.
Business growth aimed to internalize unpriced benefits, but unpriced costs
manifested in environmental crises, prompting government intervention.
 Economic History- Industrial Revolution
• The second economic revolution resulted in unequal prosperity and a
subsequent backlash against market economies.
• Labor movements with socialist and communist ideologies grew, even in
market-dominant economies, leading to more government intervention
and regulation.
• Developing countries also showed resistance to market resource allocation.
• The article presents two hypotheses to explain the tendency for market
systems to self-destruct.
• The first suggests that market competition led to ideological alienation and
political instability.
• The second posits that competition and reduced transportation costs led to
instability, prompting interest groups to seek government intervention to
reduce competitive pressures.
 Capitalist v/s Socialist?
• The transformation of Western economies in the last century, driven
by the second economic revolution, has led to increased transaction
costs.
• This growth in costs is not exclusive to capitalism (as Marxist
believed); even socialist societies face similar issues like cheating and
shirking.
• The root cause is the expansion of specialization and division of labor.
To address these challenges effectively, we need a better
understanding and analytical framework.
• This is a crucial task for modern social scientists.