Within new institutional economics, North (1990) has developed a dynamic analysis of institutional change, for according to him, neo-classical economic theory cannot explain the dynamic of change. Nevertheless, neo-classical economics still provides the central building blocks for the author. This is because institutional economics, like the neo-classical approach
”begins with the scarcity hence competition postulate; it views economics as a theory of choice subject to constraints; it employs price theory as an essential part of the analysis of institutions;
37 and it sees changes in relative prices as a major force inducing change in institutions” (North 1995). However, in order to explain change North (1991) adds institutions as a critical element to the theory, defining them as follows:
“Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct) and formal rules (constitutions, laws, property rights.) Throughout history, institutions have been devised by human beings to create order and reduce uncertainty in exchange.
Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity. They evolve incrementally, connecting the past with the present and the future… Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline” (North 1991, 97).
North (1990) also describes institutions as “rules of the game”, such that whenever humans do something together, there is always a structure, i.e. ”rules of the game”, that guides them. This structure, according to North (2005) consists of institutions – formal rules, informal norms and mechanisms that enforce these rules and norms.
However, North (1990) also draws attention to the need to differentiate institutions from organizations. Institutions are the rules of the game and organizations are the team of players that play the game according to these rules. Rules have been created so that the players would know how to play the game, with aim being to win the game. Developing strategies on how to improve the chances of a team winning the game within the commonly agreed rules (organization) and developing ideas how to change as well as further modify the rules of the game (institution) are two separate processes. Organizations are dependent on institutions in the sense that they come into existence because of inbuilt incentives in the former.
Organizations will reflect the opportunities provided by the institutions and the way they evolve is dependent on the latter. Organizations such as firms, government and NGOs operate to reproduce institutions that favour their survival. This is done within organizations by creating knowledge and innovations that strengthen the organizations and institutions (North 1990).
One central concept also for North in the theory of institutions is that of transaction costs.
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“The incomplete information and limited mental capacity by which to process information determines the costs of transacting which underlies the formation of institutions… The costs of transacting arise because information is costly and asymmetrically held by the parties of exchange…and when it is costly to transact, institutions matter” (North 1995, 18).
“NIE modifies the ‘rationality postulate’ of neo-classical economics which maintains that values are given and constant and that individual economic agents select the most efficient means of maximising rationally chosen ends” (Harriss et al. 1995, 3). North claims that individuals choose between different alternatives based on mental models. These are
”mental constructs individuals form to explain and interpret the world around them and are partly a result of their cultural heritage, partly a result of the ‘local’
everyday problems they confront and must solve, and partly a result of non-local learning” (North 2005, 61).
The concept of mental models is potentially important partly because it assists in explaining why rational individuals make irrational decisions. It also sheds light on why individuals within the same context make different choices and why nations move in different directions.
Whereas North (2005) discusses institutions mostly at the macro level, Greif (2006) is trying to establish micro-foundations for the study of institutions. The framework that he develops
“studies institutions on the level of the interacting individuals” (Grief 2006, 13). Further, his analysis is trying to combine old and new institutionalism, economic sociology and evolutionary institutionalism. Instead, of abstract econometric analyses he advocates context specific studies. For him, “an institution is a system of social factors (rules, beliefs, norms, and organizations) that together generate a regularity of (social) behaviour” (Grief 2006, 30). By regularity of behaviour, Grief refers to the reality that (most) individuals that have a ”social position” in a social situation are anticipated to behave in a certain way (Grief 2006, 32). The perspective of social position emphasises the social role in a particular situation rather than the individual’s personal characteristics and can be, e.g. a buyer, seller, lender, borrower, man/woman etc. Rules, norms, beliefs and organisations are all social, thus implying that all these institutions have been created by humans. Despite institutions being made by humans, at the same time they are exogenous to the individual. They have to be exogenous, because of their role to ”enable, guide and motivate behaviour” and can only perform this function when an individual’s relative influence is low (Grief 2006, 34). However, this does not mean that no one can change institutions. For a dictator, laws are not exogenous, since he can decide
39 whether to obey them or not as he has all the power. By contrast, a prime minister is in strong position to change formal rules, laws, but after these have been approved they are exogenous and he has to obey them. In these examples, the formal rules and laws are not institutions for the dictator or for the prime minister since they can ”initiate” change. However, even a dictator cannot change the beliefs or norms. When discussing how to ensure that rules are followed, instead of talking of enforcement, Grief (2006) uses the term motivation, which is because individuals can follow rules either because there is a threat of punishment or there is an incentive or reward. And motivation covers both alternatives.
Many institutional economists, including North (2005), have focused enforcement because they usually assume there is an external force, a third-party enforcer that ensures that rules are followed. However, there are many situations where the third-party enforcer is weak (e.g. weak states) or does not exist at all. Even in these situations rules are often enforced. In order to understand how these self-enforcing or self-motivating institutions function, the motivation as well as the beliefs and norms behind it have to be better understood.11 According to Grief (2006), a major methodological division within the students of institutions is between the agency and structuralist perspectives. The majority of economists use the former, which assumes that individuals are the agents of their lives, whereas many sociologists employ the latter, which emphasises the structures and institutions that constrain the choices that individuals have. Grief’s (2006) view is close to Giddens’ (1984) ”structuration” approach, which takes the view that there is dynamic interplay between structure and agency, thus claiming that both perspectives are needed. He is trying to bridge this divide with his definition, whereby institutions are considered as being made by humans (agency perspective,) but institutions are exogenous to individuals (structural perspective).
How institutions change: path dependence and mental models
Even though different authors have defined institutions in a slightly different ways, almost all the definitions emphasise their permanence and thus, before analysing how institutions change, it is useful to understand why they often are persistent. When explaining the rise of different types of institutions, North (2005) uses the term path dependency, referring to the situation that if one alternative has been chosen in the past, the likelihood that the same alternative will
11 In the case of most of the user owned savings and credit groups the third-party enforcement is at best weak or does not exist. Thus, studying motivation, beliefs and norms makes sense.
40 be chosen again is greater than a change being made.12 According to this author, one of the key reasons why inefficient institutions or those that do not enhance the welfare of the society continue to exist is path dependency. The origins of path dependency date back to the actor’s different decisions and actions in different geographical areas. These early choices have lead different societies to different paths. However, if the actors want to maximize their welfare, why do inefficient institutions exist? According to North (1990), this is because markets are imperfect and information feedback not satisfactory. This leads to mental models with imperfect information and ideologies that support the existing institutions instead of what could be more efficient ones (North 1990).
Path dependency is strengthened further because organisations are formed to defend existing institutions and hence, are pro the existing development path. These organisations and their leaders often have a vested interest that certain institutions are not changed. A further reason why change of institutions is difficult is that the informal norms cannot be consciously changed.
Moreover, institutions are dependent on each other meaning change in one does not take place, if others do not change. Lastly, formal rules can sometimes be changed relatively quickly, but norms have to catch up with rule changes (North 2005). Path dependency also means that change of institutions is usually incremental, because many existing organisations will oppose radical change that goes against the interests of the organisations and the institutions that they are reproducing.
For North (1990, 2005), the most important reasons for institutional change are changes in relative prices, which highlights the fact that he is trying to build NIE within the neoclassical framework. Relative prices are important because they change the incentives of individuals.
By changes in relative prices, North (1990, 2005) is referring to, e.g. changes in the ratio of land to labour, in the cost of information or changes in technology. For him, it is maximizing entrepreneurs (in the field of economy or politics), who make innovations that change relative prices (North 1990 and 2005).
How then have societies arrived at different types of formal and informal rules that guide their operations and enforce these rules? According to North (2005), rules and norms are being created on the basis of the beliefs that humans have. Where do people then get their beliefs?
They are created through learning. In his latest book, North (2005) discusses in detail the different theories of learning and concludes that humans learn through pattern recognition.
12 For a famous example see Paul David’s article “Clio and the Economics of QWERTY”.1985 American Economic Review, 75:332-37.
41 What this means in practice is that humans will find it easier to adopt new rules or norms, if the new ones are fairly similar to the existing ones. This explains, at least partly, why norms change very slowly. If mental models of actors are better understood, it is easier to understand how actors choose between different actions and what types of institutional choices are made (Schlueter 2009).