Institutions and Economic Growth: A Historical Introduction By Douglass North
In this essay, Douglass North underlines the importance that institutions have had in the economic development of the west. The classical economic models that do not consider the cost of transaction, or that take this cost as fixed, ignore a decisive element in the functioning of our economic system.
To understand the importance of institutions, one has to understand the historical evolution of trade. In primitive societies without the array of modern institutions that make trade over distance and with strangers possible, individuals were limited to trading with others in close geographic proximity who were reliable in so far as they were likely to pay or deliver--the economy was largely based on personal exchange. In order to avoid cheating, shirking or opportunism individual engaged only in trade with those who they knew well and were located nearby. Market size in this type of economy is necessarily smaller, because a small number of trading partners coupled with a small trading area limits the amount of competition and specialization that can occur.
The opposite of personal exchange is specialized interdependence. An ideal model of specialized interdependence is one in which an individual can have trade with someone at the other side of the world without fear of being cheated. Innovations like independent contract enforcers, property rights, and a developed transportation infrastructure increase both the number of people individuals can trade with and the area over which trade can occur. Personal knowledge of or geographic proximity to those who one trades with is no longer necessary, and so potential market size increases dramatically. This creates the kind of specialized economy Doug North and the classical economists like Adam Smith believed in and thought thought led to increases in the overall economic welfare of the world.
Third party institutions are vital for allowing trade between a large number of unknown agents across the world because they create security and reduce the risk of these sorts of transactions. This third party can broadly speaking be called government, but North focuses on the importance of the “institution”. Presumably, North avoids using the word “government” because he takes into account the fact that there are several international organizations and norms that also facilitate trade by increasing monitoring and enforcement capabilities.
The essay finishes with an application of the theory using the historical examples of England and Spain during the 16th and 17th centuries. With the introduction of new weapons and war tactics, war became more expensive and both kingdoms were forced to raise taxes. The English collected taxes from the population in the island, this ignited social demands and ultimately the creation of the Parliament. The Parliament being the representation of merchants increased the governmental protection of property rights. On the other hand, Spain relied on the money that was raised in the colonies, not taxing the Spanish population. This allowed the king to reduce the Cortes and the protection of property rights never took. Ultimately, England's approach led to the development of a highly specialized market system.
North, Douglass C. "Institutions and Economic Growth: A Historical Introduction." International Political Economy Perspectives on Global Power and Wealth. By Jeffry Frieden and David A. Lake. New York: Routledge, 2000. 47-59