The old aphorism that ‘deaths come in threes’ unfortunately holds at present in the economics community, with news of the passing of Douglass C. North coming not long after the loss of Herbert Scarf, the proto-market designer (The Leisure of the Theory Class 2015), and Nathan Rosenberg, who ‘opened the black box’ of the economics of innovation (Gans 2015). North’s death was also recently preceded by his two closest intellectual links: his co-recipient of the 1993 Nobel Prize, the economic historian Robert Fogel; and his co-founder of the International Society for the New Institutional Economics and 1991 Nobel laureate, Ronald Coase (Bryan 2013).
North is best known for his qualitative and empirical exploration of the rise of institutions as solutions to agency and transaction cost problems, a series of ideas that continues to be enormously influential. No economist today denies the importance of institutions. If economics is the study of the aggregation of rational choice under constraints, as it is sometimes thought to be, then North focused our mind on the origin of the constraints rather than on choice or its aggregation.
To North, “institutions are… the humanly devised constraints that shape human interaction... In consequence, they structure incentives in human exchange, whether political, social or economic” (North 1990). Why do states develop? Why do guilds, trade laws, merchant organisations, and courts appear, and when? And how does institutional persistence affect the economy over time? The latter is a question pursued at great length by Daron Acemoglu and colleagues (Acemoglu et al. 2005). These are all important questions – and it is not clear that there are better answers than the ones North provided.
Though a great historian, North was first and foremost an economist. His PhD is in economics, and even late in life he continued to apply the very most cutting edge economic tools to his studies of institutions. A wonderful example is his essay “The Role of Institutions in the Revival of Trade”, written with Paul Milgrom and Barry Weingast (Milgrom et al. 1990). This is one of the fundamental papers in ‘Analytic Narratives’, as it would later be called, a school of thought that applies formal economic theory to historical questions, particularly in the canonical work of Avner Greif and colleagues (Bryan 2012).
Here is the essential idea of the Trade Revival paper. In the late middle ages, long-distance trade, particularly at ‘Fairs’ held in specific places at specific times, arose again in Western Europe. Agency problems must have been severe: how do you keep people from cheating you, from stealing, from selling defective goods, or from reneging on granted credit?
A harmonised body of rules – the Merchant Law – appeared across many parts of Western Europe, with local courts granting judgements on the basis of this law. In the absence of nation-states, someone with a negative judgement could simply leave the local city where the verdict was handed down. The threat of not being able to sell in the future may have been sufficient to keep merchants fair, but if the threat of future lost business was the only credible punishment, then why were laws and courts needed at all? Surely merchants could simply let it be known that Johann or Giuseppe is a cheat, and that one shouldn't deal with them?
There is a puzzle here, then: it appears that the set of punishments the Merchant Law could give are identical to the set of ‘punishments’ one receives for having a bad reputation – so why then did anybody bother with courts and formal rules? In terms of modern theory, if relational contracts and formal contracts can offer identical punishments for deviating from cooperation, and formal contracts are costly, then why doesn't everyone simply rely on relational contracts?
North and his co-authors consider a simple repeated Prisoner's Dilemma. Two agents with a sufficiently high discount rate can sustain cooperation in a Prisoner's Dilemma using tit-for-tat: if you cheat me today, I cheat you tomorrow. In a repeated Prisoner's Dilemma with an arbitrary number of players who randomly match each period, cooperation can be sustained in a simple way: you cheat anyone you match with if they cheated their previous trading partner and their previous trading partner did not themselves cheat their partner two rounds ago; and otherwise cooperate.
The trick, though, is that you need to know the two-periods-back history of your current trading partner and their last trading partner. Particularly with long-distance trade, you might frequently encounter traders you don't know even indirectly. Imagine that every period you trade with someone you have never met before, and whom you will never meet again (the ‘Townsend turnpike’) with two infinite lines of traders moving in opposite directions (Townsend 1980), and imagine that you do not know the trading history of anyone you match with. In this incomplete information game, there is no punishment for cheating: you cheat the person you match with today, and no one you meet tomorrow will ever directly or indirectly learn about this. Hence cooperation is not sustained.
What we need, then, is an institution that first collects a sufficient statistic for the honesty of traders you might deal with, that provides incentives for merchants to bother to check this sufficient statistic and punish people who have cheated, and that encourages people to report if they have been cheated even if this reporting is personally costly. That is, “institutions must be designed both to keep the traders adequately informed of their responsibilities and to motivate them to do their duties”.
Consider an institution LM. When you are matched with a trading partner, you can query LM at cost Q to find out if there are any ‘unpaid judgements’ against your trading partner, and this query is common knowledge to you and your partner. You and your partner then play a trading game that is a Prisoner's Dilemma. After trading, and only if you paid the query cost Q, when you have been cheated you can pay another cost C to take your trading partner to trial. If your partner cheated you in the Prisoner's Dilemma and you took them to trial, you win a judgement penalty of J, which the cheater can either voluntarily pay you at cost c(J) or which the cheater can ignore. If the cheater doesn't pay a judgement, LM lists them as having ‘unpaid judgements’.
North and his co-authors show that under certain conditions, the following is an equilibrium where everyone always cooperates: if you have no unpaid judgements, you always query LM. If no one queries LM, or if there are unpaid judgements against your trading partner, you defect in the Prisoner's Dilemma; otherwise you cooperate. If both parties queried LM and only one defects in the Prisoner's Dilemma, the other trader pays cost C and takes the cheater to the LM for judgement. If you cheated and are taken to trial, you always pay the judgement J.
The conditions needed for this to be an equilibrium are that penalties for cheating are high enough, but not so high that cheaters prefer to retire to the countryside rather than pay them, and that the cost of querying LM is not too high. Note how the LM equilibrium encourages anyone to pay the personal cost of checking their trading partner's history: if you don't check, then you can't go to LM for judgement if you are cheated, hence you will definitely be cheated.
The LM also encourages people to pay the personal cost of putting a cheater on trial, because that is the only way to get a judgment decision, and that judgement is actually paid in equilibrium. Relying on reputation in the absence of an institution may not work if communicating reputation of someone who cheated you is personally costly: if you need to print up posters that Giuseppe cheated you, but can otherwise get no money back from Giuseppe, you are simply ‘throwing good money after bad’ and won't bother. The LM institution provides you an incentive to call out the cheats.
The only cost of the system is the cost of querying, since no one cheats in equilibrium. That is, in the sense of transactions costs, the Law Merchant may be a very low-cost institution: it generates cooperation even though only one piece of information – the existence of unpaid judgments – needs to be aggregated and communicated, and it generates cooperation among a large set of traders that never personally interact by using a single centralised ‘record-keeper’. Any system that induces cooperation must, at a minimum, inform a player whether their partner has cheated in the past. The Law Merchant system does this with no other costs in equilibrium, since in equilibrium, no one cheats, hence no one goes for judgment, hence no resources are destroyed paying fines.
That historical institutions develop largely to limit transactions costs is a major theme in North's work (North 1984), and this paper is a beautiful and highly formal explication of that broad Coasean idea. The motivating puzzle – why use formal institutions when reputation provides precisely the same potential for punishment? – can be answered simply by noting that reputation requires information, and the cost-minimising incentive-compatible way to aggregate and share that information may require an institution. The Law Merchant arises not because we need a way to punish offenders, since in the absence of the nation-state, the Law Merchant offers no method for involuntary punishment beyond those that exist in its absence; and yet, in its role reducing costs in the aggregation of information, the Law proves indispensable.
That North in so much of his work provides historical, empirical and theoretical evidence in support of the economic influence on the rise of institutions – in his own words, an idea that made him ‘a Marxist of the right’ (Farrell 2015) – is a masterclass on using the full arsenal of arrows in the economist’s quiver in support of increasing our understanding of the social world. By drawing on so many sources of knowledge-making, North is able to push much further than intellectual predecessors like John Locke, Karl Marx, and Max Weber – and hence is rightly remembered as one of the great social scientific pioneers of the modern era.
Acemoglu D, S Johnson and J Robinson (2005), "Institutions as a Fundamental Cause of Long-run Growth", in Aghion, P. and Durlauf, S. (eds) Handbook of Economic Growth, Volume 1A.
Bryan, Kevin (2012), "Game theory and history, A. Greif and friends (1993.1994)", A Fine Theorem.
Bryan, Kevin (2013), "The economic ideas of Ronald Coase", VoxEU, 10 September.
Farrell, Henry (2015), "Doug North has died", Crooked Timber.
Gans, Joshua (2015), "Nathan Rosenberg and the innovation system", Digitopoly.
The Leisure of the Theory Class (2015), "Herbert Scarf (1930-2015)".
Milgrom, Paul R., Douglass C. North, and Barry R. Weingast (1990) "The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs", Economics and Politics 2(1): 1-23.
North, Douglass C. (1984) "Transaction Costs, Institutions, and Economic History", Journal of Institutional and Theoretical Economics 140: 7-17.
North, Douglass. C. (1990), Institutions, Institutional Change, and Economic Performance, New York: Cambridge University Press.
Townsend, Robert M. (1980), "Models of Money with Spatially Separated Agents".