What difference does the explicit incorporation of institutional analysis make to the writing (and for that matter the reading) of economic history and of history in general? Writing history is constructing a coherent story of some facet of the human condition through time. Such a construction exists only in the human mind. We do not recreate the past; we construct stories about the past. But to be good history, the story must give a consistent, logical account and be constrained by the available evidence and the available theory. A brief answer to the question is that incorporating institutions into history allows us to tell a much better story than we otherwise could. The precliometric economic history actually was built around institutions, and in the hands of its most accomplished practitioners it managed to provide us with a picture of continuity and institutional change, that is, with an evolutionary story. But because it was built on bits and pieces of theory and statistics that had no overall structure, it did not lend itself to generalizations or analysis extending beyond the essentially ad hoc character of individual stories. The cliometric contribution was the application of a systematic body of theory – neoclassical theory – to history and the application of sophisticated, quantitative techniques to the specification and testing of historical models.

I now turn to two fundamental questions of societal, political, and economic change. First, what determines the divergent patterns of evolution of societies, polities, or economies over time? And how do we account for the survival of economies with persistently poor performance over long periods of time?

If we look back far enough in history, divergence appears to be very simple to explain. Bands and tribes confronted different problems with different resource endowments, different human capabilities, and in different climates. Out of these emerged different solutions to the common problems of survival, including different languages, customs, traditions, and taboos. There is no reason to believe that solutions should be similar, although there is reason to believe that they would tend to converge over time as the cost of information fell. However, after ten thousand years of civilization, despite the immense decline in information costs and despite the implications of neoclassical international trade models that would suggest convergence, there is enormous contrast between economies.

Which brings me to the second issue. What accounts for the survival of societies and economies that are characterized by persistent poor performance? Since Charles Darwin, evolutionary theory has had a powerful influence upon our understanding of social survival, and it has been embedded in the literature of economics since the publication of Armen Alchian's 1950 article.

History matters. It matters not just because we can learn from the past, but because the present and the future are connected to the past by the continuity of a society's institutions. Today's and tomorrow's choices are shaped by the past. And the past can only be made intelligible as a story of institutional evolution. Integrating institutions into economic theory and economic history is an essential step in improving that theory and history.

This study provides the outline of a theory of institutions and institutional change. Although it builds on the earlier studies of institutions that have been the focus of my attention for the past twenty years, it delves much more deeply than the earlier studies into the nature of political and economic institutions and how they change. The specification of exactly what institutions are, how they differ from organizations, and how they influence transaction and production costs is the key to much of the analysis.

The central focus is on the problem of human cooperation – specifically the cooperation that permits economies to capture the gains from trade that were the key to Adam Smith's Wealth of Nations. The evolution of institutions that create an hospitable environment for cooperative solutions to complex exchange provides for economic growth. Not all human cooperation is socially productive, of course; indeed, this study is concerned as much with explaining the evolution of institutional frameworks that induce economic stagnation and decline as with accounting for the successes.

The difference between informal and formal constraints is one of degree. Envision a continuum from taboos, customs, and traditions at one end to written constitutions at the other. The move, lengthy and uneven, from unwritten traditions and customs to written laws has been unidirectional as we have moved from less to more complex societies and is clearly related to the increasing specialization and division of labor associated with more complex societies.

The increasing complexity of societies would naturally raise the rate of return to the formalization of constraints (which became possible with the development of writing), and technological change tended to lower measurement costs and encourage precise, standardized weights and measures. The creation of formal legal systems to handle more complex disputes entails formal rules; hierarchies that evolve with more complex organization entail formal structures to specify principal/agent relationships. The general characteristics of the shift from status to contract have been amply discussed, but it is worth emphasizing the following.

Formal rules can complement and increase the effectiveness of informal constraints. They may lower information, monitoring, and enforcement costs and hence make informal constraints possible solutions to more complex exchange (see Milgrom, North, and Weingast, 1990, and Chapter 7 for elaboration). Formal rules also may be enacted to modify, revise, or replace informal constraints.

Of the three game forms, it is the extensive form, or the game tree, that provides the most detailed description of the actions that are available to the players. I shall argue that, as was the case with the other two game forms, this description is not adequate. On the one hand, it fails to specify, for example, the legal institutions, such as whether it is possible for a player to selfcommit to his future actions. [It is the answer to this question that lies at the heart of the distinction between Nash and subgame perfect equilibria (see Definitions 8.0.3 and 8.0.4).] And, on the other hand, it involves unnecessarily detailed information:

Insisting on such a detailed description is not only “wasteful”; it also has serious consequences.

In this chapter the theory of social situations is applied to the problem of implementing a social choice rule. As was the case in the previous chapters, here, too, this application yields a new result within the implementation area itself – the characterization of social choice rules that satisfy the strong positive association condition (Definition 10.1.1) – and, in addition, sheds new light on this condition by pointing out its strategic (rather than normative) aspect.

Moreover, the methodology developed in this chapter is likely to prove useful in the important task of incorporating, into the theory of social situations, social environments where individuals have incomplete and/or imperfect information (in particular, about the preferences of the other players they are facing). (See also Section 11.9.)

Definition 10.0.1: A society is a triple (N,A,{ui}i∈N, where N is the set of individuals, A is the set of feasible social alternatives, and for i∈N, ui denotes individual i's utility function over A,ui:A→ℝ.

The problem of implementation concerns circumstances in which “the social planner” does not know the society he is facing. His knowledge is limited only to the class of “potential societies.” That is, although he does know the sets N and A, he has only partial information concerning the preferences of the individuals. Specifically, the social planner knows, for each i∈N, the set of utility functions, Ui to which “the true” preferences of individual i belong.

Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction. In consequence they structure incentives in human exchange, whether political, social, or economic. Institutional change shapes the way societies evolve through time and hence is the key to understanding historical change.

That institutions affect the performance of economies is hardly controversial. That the differential performance of economies over time is fundamentally influenced by the way institutions evolve is also not controversial. Yet neither current economic theory nor cliometric history shows many signs of appreciating the role of institutions in economic performance because there as yet has been no analytical framework to integrate institutional analysis into economics and economic history. The objective of this book is to provide such an underlying framework. The implications of the analysis suggest a reexamination of much social science theorizing in general and economics in particular, and provide a new understanding of historical change.

In this study I examine the nature of institutions and the consequences of institutions for economic (or societal) performance (Part I). I then outline a theory of institutional change not only to provide a framework for economic (and other) history, but also to explain how the past influences the present and future, the way incremental institutional change affects the choice set at a moment of time, and the nature of path dependence (Part II).

Institutions provide the basic structure by which human beings throughout history have created order and attempted to reduce uncertainty in exchange. Together with the technology employed, they determine transaction and transformation costs and hence the profitability and feasibility of engaging in economic activity. They connect the past with the present and the future so that history is a largely incremental story of institutional evolution in which the historical performance of economies can only be understood as a part of a sequential story. And they are the key to understanding the interrelationship between the polity and the economy and the consequences of that interrelationship for economic growth (or stagnation and decline). But just why are some forms of exchange stable while others lead to more complex and productive forms of exchange? I have discussed the theoretical issues of institutional change. Here I wish to explore the specific characteristics of historical change.

In examining stability and change in history, the initial issue is the same one posed at the beginning of this study (see Chapter 2). What combination of institutions permits capturing the gains from trade inherent in the standard neoclassical (zero transaction cost) model at any moment of time? The issue is complicated enough in an ahistorical context. It is vastly more complicated in history, because rather than starting with a tabula rasa, history is always derived from past history.

My theory of institutions is constructed from a theory of human behavior combined with a theory of the costs of transacting. When we combine them we can understand why institutions exist and what role they play in the functioning of societies. If we add a theory of production we can then analyze the role of institutions in the performance of economies.

The costliness of information is the key to the costs of transacting, which consist of the costs of measuring the valuable attributes of what is being exchanged and the costs of protecting rights and policing and enforcing agreements. These measurement and enforcement costs are the sources of social, political, and economic institutions. The rest of this chapter concentrates on economic exchange; in Chapter 6 I will build a model of political exchange from the same building blocks.

The costliness of economic exchange distinguishes the transaction costs approach from the traditional theory economists have inherited from Adam Smith. For 200 years the gains from trade made possible by increasing specialization and division of labor have been the cornerstone of economic theory. Specialization could be realized by increasing the size of markets, and as the world's economy grew and division of labor became ever more specific, the number of exchanges involved in the performance of economies expanded. But the long line of economists who built this approach into an elegant body of economic theory did so without regard to the costliness of this exchange process.

There is a persistent tension in the social sciences between the theories we construct and the evidence we compile about human interaction in the world around us. It is most striking in economics, where the contrast between the logical implications of neoclassical theory and the performance of economies (however defined and measured) is startling. Certainly neoclassical theory has been a major contribution to knowledge and works well in the analysis of markets in developed countries. At the other end of the scale, however, it does not provide much insight into such organizations as the medieval manor, the Champagne fairs, or the suq (the bazaar market that characterizes much of the Middle East and North Africa). Not only does it not characterize these organizations' exchange process very well, it does not explain the persistence for millennia of what appear to be inefficient forms of exchange.

The disparity in the performance of economies and the persistence of disparate economies through time have not been satisfactorily explained by development economists, despite forty years of immense effort. The simple fact is that the theory employed is not up to the task. The theory is based on the fundamental assumption of scarcity and hence competition; its harmonious implications come from its assumptions about a frictionless exchange process in which property rights are perfectly and costlessly specified and information is likewise costless to acquire.

The Cambridge Series in the Political Economy of Institutions and Decisions is built around attempts to answer two central questions: How do institutions evolve in response to individual incentives, strategies, and choices, and how do institutions affect the performance of political and economic systems? The scope of the series is comparative and historical rather than international or specifically American, and the focus is positive rather than normative.

In this challenging theoretical work, Douglass North examines how to explain the vastly different performances of economies over long periods of time. Asking “What combination of institutions best permits capturing the gains from trade?”, he offers a broad perspective on how institutions persist and change, superseding his own earlier work on incentives toward efficient institutions. Now his focus is on the interaction of institutions, defined as any constraint humans devise to shape their interactions, and organizations, created to take advantage of the opportunities presented by institutions in shaping the development of economies. The importance of institutions arises from the costliness of measuring what is valuable, protecting rights, and policing and enforcing agreements. Once created, institutions determine the costs of acting in various ways in political and economic contexts. North applies his theories of the interplay between institutional evolution and political and economic organization to a range of historical examples, including the development of management structures, law merchants, insurance, and financial markets.

We cannot see, feel, touch, or even measure institutions; they are constructs of the human mind. But even the most convinced neoclassical economists admit their existence and typically make them parameters (implicitly or explicitly) in their models. Do institutions matter? Do tariffs, regulations, and rules matter? Does government make a difference? Can we explain the radical change in economic well-being when we step across the boundary between the United States and Mexico? What makes markets work or not work? Does honesty in exchange make a difference; does it pay? I hope that the analysis of the previous chapters has provided a convincing framework to shed light on the consequences of institutions.

But I wish to assert a much more fundamental role for institutions in societies; they are the underlying determinant of the long-run performance of economies. If we are ever to construct a dynamic theory of change – something missing in mainstream economics and only very imperfectly dealt with in Marxian theory – it must be built on a model of institutional change. Although some of the pieces of the puzzle are still missing, the outline of the direction to be taken is, I believe, clear.

In the sections that follow I (1) specify what changes must be made in neoclassical theory to incorporate institutional analysis into that theory, (2) outline the implications for the static analysis of economic performance, and (3) explore the implications of institutional analysis for the construction of a dynamic theory of long-run economic change.