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Culture and Economic History

Understanding the Process of Economic Change by Douglass C North


Culture and Economic History

Understanding the Process of Economic Change

by Douglass C North; Academic Foundation, New Delhi, 2005; pp xii + 187, Rs 695.


“If North were a speculator, investing in

ideas, it would pay handsomely to follow his long-term choices”, writes one contributor to a widely cited collection of essays [Arthur 1997]. Understanding the Process of Economic Change illustrates the truth of this statement. In this book, Douglass North pursues a line of thought introduced but not followed up in his earlier writings, that belief and cultural expectations are an important agent of economic change. Economists and economic historians have of late tried to grapple with the role of culture. The book supplies a framework for such projects.

A part of this framework will be familiar to students of economic growth and economic history. This part should consist of the following propositions.

Basic Framework

Neoclassical economic theory is a limited tool for analysing the process of economic change. For, while being a theory of choice, it neglects the context in which choices are made. The presence of uncertainty is a key feature of this context. Constantly present attempts to deal with this condition make the world we live in “non-ergodic”, that is, one that does not have a stable underlying structure.1 Institutions are an outcome of these attempts, and a response to the need to reduce uncertainty and make the environment more predictable.

“Institutions are humanly devised constraints that structure human interaction”, or more simply, institutions are rules by which production and exchange occur [North 1994]. Institutions can be formal, such as laws, and informal, such as norms. Institutions are different from organisations. Organisations are collective bodies that have definite objectives, such as earning a profit or doing good work for society. But they do not create rules. “Institutions are the rules of the game, organisations are the players” (p 59). A company is an organisation. The Companies Act is an institution. However, the relationship between them is important. Individuals belong in collectives. Institutional change requires collective action. Therefore, organisations play a role in translating individuals’ wishes regarding institutional continuity or change into action. Institutions, together with the means to enforce rules, create an incentive structure, that is, encourage individuals to take certain actions in preference to others. If you live in a society where laws on contract or fraud are weak or enforced poorly, the institutions encourage fraud. If you live in a society where there are legal safeguards against fraud and these are enforced properly, institutions encourage honest conduct.

There are various sources and forms of uncertainty. Impersonal exchange is beset with transaction costs. In the context of market transactions, transaction costs are the costs entailed in measurement and enforcement of agreements. One principal kind of transaction cost stems from asymmetric information – for example, unequal knowledge of buyers and sellers about the quality of a good transacted potentially induces one party to cheat the other. If institutions exist to reduce transaction costs, more transactions will occur, and following a path that Adam Smith had first outlined, economic growth could occur.

That being said, there is no certainty that institutions would actually serve the collective good and ensure economic growth. This is a crucial point which, according to North, is a great differentiator between the west and the developing world. Rules can be made to serve interest groups or a predatory state at the cost of others. Institutions can reduce uncertainty for some members of a society and increase uncertainty for other members. “It is the polity that defines and enforces the formal economic rules of the game” (p 57). Here we encounter a fundamental dilemma of history. Polities that are strong enough to enforce the rules of the game are also strong enough to bend the rules in favour of factions or particular players. There is indeed no way by which societies can control or direct this process.

Subsequent research by North and others suggests one of the conditions that would make it likely that strong polities would serve the collective good. The key phrase is “credible commitments” [North and Weingast 1989]. Some degree of competition in the market for political power is likely to lead to credible commitments made by one dominant player to other players to work in mutual interest. One example is the balance of power, secured by formal agreements, between the Crown and the Parliament in early modern England. There were two important consequences of this balance of power. First, the belief that common law was the supreme law of the land took shape. Second, a connection was drawn between monopoly and denial of liberty. Medieval Europe shows a similar balance of power between the princes and merchants, which led to a definition and protection of property rights. But these were exceptions. A great deal of history illustrates something that is quite the opposite. A spate of predatory dictatorships and what Mancur Olson called “distributional coalitions” capture the state and frustrate the emergence of institutions that could serve collective good [Olson 1984].

This summary of the new institutional economics in the context of economic history is known to the well-read student, though the book contains fresh and important discussions on political processes. But the book also develops two critical ingredients in this story that are not so well-known. These are: the role of beliefs in institutional change, and the role of institutions in extending the stock of useful knowledge. Culture and knowledge are integrated with institutions in this book.


Three chapters examine the consequences of the premise that institutional change is an intentional process. How do these intentions form? North takes us back to cognitive science for tentative and exploratory answers to this question. As Andy Clark has shown in a key contribution, computational cognitive science suggests the different ways that the brain works in making decisions, of which only

Economic and Political Weekly April 21, 2007 a limited set of ways, where choices are “scaffolded” by the external structure, conform to the rationality assumption of neoclassical economics [Clark 1996].

Of greater relevance to the project of this book is the historically informed point that “cultural heritage provides the artifactual structure” that leads to institutional change. The book describes two principal forms of cultural adaptation through human history. The first involves construction of a belief system to deal with the physical environment and the second involves construction of a belief system to deal with the complex problems of the human environment. Human history between origins about three million years ago and the advent of knowledge-driven economies a few hundred years ago shows that the first form of challenge was more or less successfully met. A successful transition from the first to the second, on the other hand, is “at the core of the problems of economic development. There is nothing automatic about such a transition being successful” (p 44). What is involved in this transition is a shift from a collectivist society based on cooperation, hierarchy, and respect for ranks, to an individualist one based on choice, democratic governance, competence, and tolerance for differentiation.

In illustrating successful transitions, North uses Avner Greif’s influential study of two late medieval merchant groups, the Maghribis and the Genoese, on several occasions [Greif 1994]. This study contrasts two models of enforcement of collective action. One of these was based on personalised and social communications, which were effective in dealings within relatively homogeneous ethnic groups. In the other case, political and economic institutions evolved in a manner that could lead more easily into the evolution of laws and make impersonal exchange possible and easier. North adds to accounts such as these the agency of beliefs that might enable a group “to visualise the consequences of a world in which there were favourable pay-offs to impersonal exchange” (p 119).

The other point that receives stress is that institutions must provide incentives for individuals and organisations to engage in learning and acquisition of useful knowledge. The first principle here is that organisations must compete, and compete by investing in learning (p 60). But that is not enough. In Adam Smith’s view of economic growth, specialisation and division of labour improve accuracy and skill, and are means to improving productivity. But specialisation also introduces a particular kind of transaction cost, “that of ascertaining the (measurement and performance) characteristics of goods and services acquired which are alien to one’s specialised knowledge” (p 73). Integrating dispersed knowledge, therefore, is more than a matter of creating market exchange. The point leads us back to transaction costs, where this review began.


To be completely persuaded by this framework and to begin using it, one would need some illustrations of failed, delayed, and aborted growth. On this point the book does not have a lot to offer. Nearly all of North’s illustrations come from the west. The book is practically silent on developing countries. In the spirit of the now discredited modernisation theory of the 1950s, what is missing in the developing countries is suggested with reference to what worked well for the modern west. In this diagnosis, poor countries stayed poor apparently because of wrong polities and collectivist belief systems. This is at best a half-truth. At any rate, it is not established. I have two specific problems with such a paradigm.

First, while North slips in “good luck” as an explanatory variable when discussing the US, he does not explicitly tackle the factor of luck. Clearly, in explaining why North America became rich while sub-Saharan Africa stayed poor, it would be unwise to overlook the enormous difference between them in natural resource endowments. This is not an isolated example. The physical environment and the quality of land and water resources still pose huge challenges to many societies, including and especially those located in the tropics, and these societies meet the challenges in diverse ways, often with lasting effects. The somewhat black-andwhite distinction between good and bad institutions is unhelpful in writing that history. Luck, of course, is not everything. But nor are institutions.

Second, identifying non-western societies with non-western cultures, beliefs or institutions would amount to a caricature of history. Institutional structures the world over but especially in former colonies and regions that were under direct or indirect influence of the Atlantic economy since the 19th century, are hybrids. For over 200 years, today’s developing world has seen a three-fold process at work, westernisation of formal rules, atrophy of informal rules, and conscious recreation of tradition partly as a reaction to the first tendency. If the outcome of such twisted evolutions fail to perform, the roots of the failure may well lie in the manner in which western rules were grafted on to native norms, western intrusion sometimes uprooted native norms as in Africa, interest groups could exploit the process of hybridisation, and bad traditions were revived by local societies to serve sectarian interests or simply as a xenophobic reaction. I do not wish to argue that westernisation was a good thing or a bad thing. The point rather is that all attempts to place the west and the non-west in two distinct cultural boxes are likely to fail. The point is that simple keywords such as “collectivist beliefs”, “predatory states” or “path-dependent evolutions” are poor guides to third world history.

Understanding the Process of Economic Change is a work of great wisdom, innovation, and elegance. With a few simple elements, North’s writings erect a scaffold that has transformed the way historians construct stories of economic change. This book simultaneously takes stock of and advances the project. It also makes the reader aware of how far away we are from a reasonably complete explanation of why the growth impulse fails on so many occasions.




1 The “ergodic process” refers to a series of data that have identical statistical properties whether a sample is taken over time or across a population.


Arthur, W Bian (1997): ‘Beyond Rational Expectations: Indeterminacy in Economic and Financial Markets’ in J N Dobak and J V C Nye (eds), The Frontiers of the New Institutional Economics, Academic Press, San Diego.

Clark, A (1996): ‘Economic Reason: The Interplay of Individual Learning and External Structure’ in Drobak and Nye (eds), The Frontiers of the New Institutional Economics, Academic Press, San Diego.

Greif, A (1994): ‘Cultural Beliefs and the Organisation of Society: A Historical and Theoretical Reflection on Collectivist and Individualist Societies’, Journal of Political Economy, Vol 102, No 5, pp 912-50.

North, D C (1994): ‘Economic Performance Through Time’, American Economic Review, Vol 84, No 3, pp 359-68.

North, D C and B R Weingast (1989): ‘Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth Century England’, Journal of Economic History, Vol 49, No 4, pp 803-32.

Olson, M (1984): The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities, Yale University Press, New Haven.

Economic and Political Weekly April 21, 2007

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