Douglass C.

North
Prize Lecture
Lecture to the memory of Alfred Nobel, December 9, 1993

Economic Performance through Time

I
Economic history is about the performance of economies through time. The objective of
research in the field is not only to shed new light on the economic past but also to contribute
to economic theory by providing an analytical framework that will enable us to understand
economic change. A theory of economic dynamics comparable in precision to general
equilibrium theory would be the ideal tool of analysis. In the absence of such a theory we can
describe the characteristics of past economies, examine the performance of economies at
various times, and engage in comparative static analysis; but missing is an analytical
understanding of the way economies evolve through time.
A theory of economic dynamics is also crucial for the field of economic development. There
is no mystery why the field of development has failed to develop during the five decades
since the end of the second World War. Neo-classical theory is simply an inappropriate tool
to analyze and prescribe policies that will induce development. It is concerned with the
operation of markets, not with how markets develop. How can one prescribe policies when
one doesn’t understand how economies develop? The very methods employed by neo-
classical economists have dictated the subject matter and militated against such a
development. That theory in the pristine form that gave it mathematical precision and
elegance modeled a frictionless and static world. When applied to economic history and
development it focused on technological development and more recently human capital
investment, but ignored the incentive structure embodied in institutions that determined the
extent of societal investment in those factors. In the analysis of economic performance
through time it contained two erroneous assumptions: one that institutions do not matter and
two that time does not matter.

This essay is about institutions and time. It does not provide a theory of economic dynamics
comparable to general equilibrium theory.1 We do not have such a theory.’ Rather it provides
the initial scaffolding of an analytical framework capable of increasing our understanding of
the historical evolution of economies and a necessarily crude guide to policy in the ongoing
task of improving the economic performance of economies. The analytical framework is a
modification of neo-classical theory. What it retains is the fundamental assumption of
scarcity and hence competition and the analytical tools of micro-economic theory. What it
modifies is the rationality assumption. What it adds is the dimension of time.
Institutions form the incentive structure of a society and the political and economic
institutions, in consequence, are the underlying determinant of economic performance. Time
as it relates to economic and societal change is the dimension in which the learning process
of human beings shapes the way institutions evolve. That is, the beliefs that individuals,
groups, and societies hold which determine choices are a consequence of learning through
time – not just the span of an individual’s life or of a generation of a society but the learning
embodied in individuals, groups, and societies that is cumulative through time and passed on
intergenerationally by the culture of a society.
The next two sections of this essay summarize the work I, and others, have done on the
nature of institutions and the way they affect economic performance (II) and then
characterize the nature of institutional change (III).2 The remaining four sections describe a
cognitive science approach to human learning (IV); provide an institutional/cognitive
approach to economic history (V); indicate the implications of this approach for improving
our understanding of the past (VI); and finally suggest implications for current development
policies (VII).
II
Institutions are the humanly devised constraints that structure human interaction. They are
made up of formal constraints (rules, laws, constitutions), informal constraints (norms of
behavior, conventions, and self imposed codes of conduct), and their enforcement
characteristics. Together they define the incentive structure of societies and specifically
economies. Institutions and the technology employed determine the transaction and
transformation costs that add up to the costs of production. It was Ronald Coase (1960) who
made the crucial connection between institutions, transaction costs, and neo-classical theory.
The neo-classical result of efficient markets only obtains when it is costless to transact. Only
under the conditions of costless bargaining will the actors reach the solution that maximizes
aggregate income regardless of the institutional arrangements. When it is costly to transact
then institutions matter. And it is costly to transact. Wallis and North (1986) demonstrated in
an empirical study that 45 percent of U.S. GNP was devoted to the transaction sector in 1970.
Efficient markets are created in the real world when competition is strong enough via
arbitrage and efficient information feedback to approximate the Coase zero transaction cost
conditions and the parties can realize the gains from trade inherent in the neo-classical
argument.
But the informational and institutional requirements necessary to achieve such efficient
markets are stringent. Players must not only have objectives but know the correct way to
achieve them. But how do the players know the correct way to achieve their objectives? The
instrumental rationality answer is that even though the actors may initially have diverse and
erroneous models, the informational feedback process and arbitraging actors will correct
initially incorrect models, punish deviant behavior and lead surviving players to correct
models.

An even more stringent implicit requirement of the discipline-of-the-competitive-market

model is that when there are significant transaction costs, the consequent institutions of the
market will be designed to induce the actors to acquire the essential information that will lead
them to correct their models. The implication is not only that institutions are designed to
achieve efficient outcomes but that they can be ignored in economic analysis because they
play no independent role in economic performance.

These are stringent requirements that are realized only very exceptionally. Individuals
typically act on incomplete information and with subjectively derived models that are
frequently erroneous; the information feedback is typically insufficient to correct these
subjective models. Institutions are not necessarily or even usually created to be socially
efficient; rather they, or at least the formal rules, are created to serve the interests of those
with the bargaining power to create new rules. In a world of zero transaction costs,
bargaining strength does not affect the efficiency of outcomes; but in a world of positive
transaction costs it does.

It is exceptional to find economic markets that approximate the conditions necessary for
efficiency. It is impossible to find political markets that do. The reason is straightforward.
Transaction costs are the costs of specifying what is being exchanged and of enforcing the
consequent agreements. In economic markets what is being specified (measured) is the
valuable attributes – the physical and property rights dimensions – of goods and services or
the performance of agents. While measurement can frequently be costly, there are some
standard criteria: the physical dimensions have objective characteristics (size, weight, color,
etc.) and the property rights dimensions are defined in legal terms. Competition also plays a
critical role in reducing enforcement costs. The judicial system provides coercive
enforcement. Still, economic markets in the past and present are typically imperfect and beset
by high transaction costs.

Measuring and enforcing agreements in political markets is far more difficult. What is being
exchanged (between constituents and legislators in a democracy) is promises for votes. The
voter has little incentive to become informed because the likelihood that one’s vote matters is
infinitesimal; further the complexity of the issues produces genuine uncertainty. Enforcement
of political agreements is beset by difficulties. Competition is far less effective than in
economic markets. For a variety of simple, easy-to-measure and important-to-constituent-
well-being policies, constituents may be well informed, but beyond such straightforward
policy issues ideological stereotyping takes over and (as I shall argue below in section IV)
shapes the consequent performance of economies.3 It is the polity that defines and enforces
property rights and in consequence it is not surprising that efficient economic markets are so
exceptional.
III
It is the interaction between institutions and organizations that shapes the institutional
evolution of an economy. If institutions are the rules of the game, organizations and their
entrepreneurs are the players.
Organizations are made up of groups of individuals bound together by some common
purpose to achieve certain objectives. Organizations include political bodies (political parties,
the Senate, a city council, regulatory bodies), economic bodies (firms, trade unions, family
farms, cooperatives), social bodies (churches, clubs, athletic associations), educational bodies
(schools, universities, vocational training centers).

The organizations that come into existence will reflect the opportunities provided by the
institutional matrix. That is, if the institutional framework rewards piracy then piratical
organizations will come into existence; and if the institutional framework rewards productive
activities then organizations – firms – will come into existence to engage in productive
activities.

Economic change is a ubiquitous, ongoing, incremental process that is a consequence of the

choices individual actors and entrepreneurs of organizations are making every day. While the
vast majority of these decisions are routine (Nelson and Winter, 1982) some involve altering
existing “contracts” between individuals and organizations. Sometimes that recontracting can
be accomplished within the existing structure of property rights and political rules; but
sometimes new contracting forms require an alteration in the rules. Equally, norms of
behavior that guide exchanges will gradually be modified or wither away. In both instances,
institutions are being altered.

Modifications occur because individuals perceive that they could do better by restructuring
exchanges (political or economic). The source of the changed perceptions may be exogenous
to the economy – for instance a change in the price or quality of a competitive product in
another economy that alters perceptions of entrepreneurs in the given economy about
profitable opportunities. But the most fundamental long run source of change is learning by
individuals and entrepreneurs of organizations.
While idle curiosity will result in learning, the rate of learning will reflect the intensity of
competition amongst organizations. Competition, reflecting ubiquitous scarcity, induces
organizations to engage in learning to survive. The degree of competition can and does vary.
The greater the degree of monopoly power the lower the incentive to learn.

The speed of economic change is a function of the rate of learning but the direction of that
change is a function of the expected pay-offs to acquiring different kinds of knowledge. The
mental models that the players develop shape perceptions about the pay-offs.

IV
It is necessary to dismantle the rationality assumption underlying economic theory in order to
approach constructively the nature of human learning. History demonstrates that ideas,
ideologies, myths, dogmas, and prejudices matter; and an understanding of the way they
evolve is necessary for further progress in developing a framework to understand societal
change. The rational choice framework assumes that individuals know what is in their self
interest and act accordingly. That may be correct for individuals making choices in the highly
developed markets of modern economies4 but it is patently false in making choices under
conditions of uncertainty – the conditions that have characterized the political and economic
choices that shaped (and continue to shape) historical change.
Herbert Simon has stated the issues succinctly:

If… we accept the proposition that both the knowledge and the computational
power of the decision-maker are severely limited, then we must distinguish
between the real world and the actor’s perception of it and reasoning about it.
That is to say we must construct a theory (and test it empirically) of the process
of decision. Our theory must include not only the reasoning processes but also
the processes that generated the actor’s subjective representation of the decision
problem, his or her frame. (Simon, 1986, pp. S210-11)
The analytical framework we must build, must originate in an understanding of how human
learning takes place. We have a way to go before we can construct such a theory but
cognitive science has made immense strides in recent years – enough strides to suggest a
tentative approach that can help us understand decision making under uncertainty.5
Learning entails developing a structure by which to interpret the varied signals received by
the senses. The initial architecture of the structure is genetic but the subsequent scaffolding is
a result of the experiences of the individual. The experiences can be classified into two kinds
– those from the physical environment and those from the socio-cultural linguistic
environment. The structures consist of categories – classifications that gradually evolve from
earliest childhood to organize our perceptions and keep track of our memory of analytic
results and experiences. Building on these classifications, we form mental models to explain
and interpret the environment – typically in ways relevant to some goal. Both the categories
and the mental models will evolve, reflecting the feedback derived from new experiences:
feedback that sometimes strengthens our initial categories and models or may lead to
modifications – in short, learning. Thus, the mental models may be continually redefined
with new experiences, including contact with others’ ideas.

At this juncture the learning process of human beings diverges from that of other animals
(such as the sea slug – a favorite research subject of cognitive scientists) and particularly
diverges from the computer analogy that dominated early studies of artificial intelligence.
The mind appears to order and reorder the mental models from their special purpose origins
to successively more abstract form so that they become available to process other
information. The term used by Clark and Karmiloff-Smith (1993) is representational
redescription. The capacity to generalize from the particular to the general and to use analogy
is a part of this redescription process. It is this capacity that is the source not only of creative
thinking but also of the ideologies and belief systems that underlie the choices humans
make.6
A common cultural heritage provides a means of reducing the divergence in the mental
models that people in a society have, and constitutes the means for the intergenerational
transfer of unifying perceptions. In pre-modern societies cultural learning provided a means
of internal communication; it also provided shared explanations for phenomena outside the
immediate experiences of the members of society in the form of religions, myths and
dogmas. Such belief structures are not, however, confined to primitive societies but are an
essential part of modern societies as well.

Belief structures get transformed into societal and economic structures by institutions- both
formal rules and informal norms of behavior. The relationship between mental models and
institutions is an intimate one. Mental models are the internal representations that individual
cognitive systems create to interpret the environment; institutions are the external (to the
mind) mechanisms individuals create to structure and order the environment

V
There is no guarantee that the beliefs and institutions that evolve through time will produce
economic growth. Let me pose the issue that time presents us by a brief
institutional/cognitive story of long-run economic/political change.
As tribes evolved in different physical environments they developed different languages and,
with different experiences, different mental models to explain the world around them. The
languages and mental models formed the informal constraints that defined the institutional
framework of the tribe and were passed down intergenerationally as customs, taboos, and
myths that provided cultural continuity.7
With growing specialization and division of labor the tribes evolved into polities and
economies; the diversity of experience and learning produced increasingly different societies
and civilizations with different degrees of success in solving the fundamental economic
problem of scarcity. The reason is that as the complexity of the environment increased as
human beings became increasingly interdependent, more complex institutional structures
were necessary to capture the potential gains from trade. Such evolution requires that the
society develop institutions that will permit anonymous, impersonal exchange across time
and space. To the extent that the culture and local experiences had produced diverse
institutions and belief systems with respect to the gains from such cooperation, the likelihood
of creating the necessary institutions to capture the gains from trade of more complex
contracting varied. In fact most societies throughout history got “stuck” in an institutional
matrix that did not evolve into the impersonal exchange essential to capturing the
productivity gains that came from the specialization and division of labor that have produced
the Wealth of Nations.

The key to the foregoing story is the kind of learning that the individuals in a society
acquired through time. Time in this context entails not only current experiences and learning
but also the cumulative experience of past generations that is embodied in culture. Collective
learning – a term used by Hayek – consists of those experiences that have passed the slow
test of time and are embodied in our language, institutions, technology, and ways of doing
things. It is “the transmission in time of our accumulated stock of knowledge” (Hayek 1960:
27). It is culture that provides the key to path dependence – a term used to describe the
powerful influence of the past on the present and future. The current learning of any
generation takes place within the context of the perceptions derived from collective learning.
Learning then is an incremental process filtered by the culture of a society which determines
the perceived pay-offs, but there is no guarantee that the cumulative past experience of a
society will necessarily fit them to solve new problems. Societies that get “stuck” embody
belief systems and institutions that fail to confront and solve new problems of societal
complexity.

We need to understand a great deal more about the cumulative learning of a society. The
learning process appears to be a function of 1) the way in which a given belief structure
filters the information derived from experiences; and 2) the different experiences confronting
individuals and societies at different times. The perceived rate of return (private) may be high
to military technology (in medieval Europe), to the pursuit and refinement of religious dogma
(Rome during and after Constantine) or to the research for an accurate chronometer to
determine longitude at sea (for which a substantial reward was offered during the age of
exploration).

The incentives to acquire pure knowledge, the essential underpinning of modern economic
growth, are affected by monetary rewards and punishments; they are also fundamentally
influenced by a society’s tolerance of creative developments, as a long list of creative
individuals from Galileo to Darwin could attest. While there is a substantial literature on the
origins and development of science, very little of it deals with the links between institutional
structure, belief systems and the incentives and disincentives to acquire pure knowledge. A
major factor in the development of Western Europe was the gradual perception of the utility
of research in pure science.

Incentives embodied in belief systems as expressed in institutions determine economic

performance through time, and however we wish to define economic performance the
historical record is clear. Throughout most of history and for most societies in the past and
present, economic performance has been anything but satisfactory. Human beings have, by
trial and error, learned how to make economies perform better; but not only has this learning
taken ten millennia (since the first economic revolution) – it has still escaped the grasp of
almost half of the world’s population. Moreover the radical improvement in economic
performance, even when narrowly defined as material well-being, is a modern phenomenon
of the last few centuries and confined until the last few decades to a small part of the world.
Explaining the pace and direction of economic change throughout history presents a major
puzzle.

Let us represent the human experience to date as a 24 hour clock in which the beginning
consists of the time (apparently in Africa between 4 and 5 million years ago) when humans
became separate from other primates. Then the beginning of so-called civilization occurs
with the development of agriculture and permanent settlement in about 8000 B.C. in the
Fertile Crescent – in the last three or four minutes of the clock. For the other twenty three
hours and fifty six or seven minutes, humans remained hunters and gatherers and while
population grew it did so at a very slow pace.

Now if we make a new 24 hour clock for the time of civilization – the ten thousand years
from development of agriculture to the present – the pace of change appears to be very slow
for the first 12 hours although our archeological knowledge is very limited. Historical
demographers speculate that the rate of population growth may have doubled as compared to
the previous era but still was very slow. The pace of change accelerates in the past five
thousand years with the rise and then decline of economies and civilizations. Population may
have grown from about three hundred million at the time of Christ to about eight hundred
million by 1750 – a substantial acceleration as compared to earlier rates of growth. The last
250 years – just 35 minutes on our new 24 hour clock – are the era of modern economic
growth accompanied by a population explosion that now puts world population in excess of
five billion.

If we focus now on the last 250 years we see that growth was largely restricted to Western
Europe and the overseas extensions of Britain for 200 of those 250 years.

Not only has the pace varied over the ages; the change has not been unidirectional. That is
not simply a consequence of the decline of individual civilizations; there have been periods
of apparent secular stagnation – the most recent being the long hiatus between the end of the
Roman Empire in the west and the revival of Western Europe approximately five hundred
years later.

VI
What can an institutional/cognitive approach contribute to improving our understanding of
the economic past? First of all it should make sense out of the very uneven pattern of
economic performance described in the previous section. There is nothing automatic about
the evolving of conditions that will permit low cost transacting in the impersonal markets that
are essential to productive economies. Game theory characterizes the issue. Individuals will
usually find it worthwhile cooperating with others in exchange when the play is repeated,
when they possess complete information about the other player’s past performance, and when
there are small numbers of players. Cooperation is difficult to sustain when the game is not
repeated (or there is an endgame), when information about the other players is lacking, and
when there are large numbers of players. Creating the institutions that will alter the
benefit/cost ratios in favor of cooperation in impersonal exchange is a complex process
because it not only entails the creation of economic institutions but requires that they be
undergirded by appropriate political institutions.
We are just beginning to explore the nature of this historical process. The remarkable
development of Western Europe from relative backwardness in the tenth century to world
economic hegemony by the eighteenth century is a story of a gradually evolving belief
system in the context of competition among fragmented political/economic units producing
economic institutions and political structure that produced modern economic growth.8 And
even within Western Europe there were successes (The Netherlands and England) and
failures (Spain and Portugal) reflecting diverse external environmental experiences.9
Second, institutional/cognitive analysis should explain path dependence, one of the
remarkable regularities of history. Why do economies once on a path of growth or stagnation
tend to persist? Pioneering work on this subject is beginning to give us insights into the
sources of path dependence (Arthur, 1989 and David, 1985). But there is much that we still
do not know. The rationality assumption of neo-classical theory would suggest that political
entrepreneurs of stagnating economies could simply alter the rules and change the direction
of failed economies. It is not that rulers have been unaware of poor performance. Rather the
difficulty of turning economies around is a function of the nature of political markets and,
underlying that, the belief systems of the actors. The long decline of Spain, for example, from
the glories of the Habsburg Empire of the sixteenth century to its sorry state under Franco in
the twentieth century was characterized by endless self appraisals and frequently bizarre
proposed solutions.10
Third, this approach will contribute to our understanding of the complex interplay between
institutions, technology, and demography in the overall process of economic change. A
complete theory of economic performance would entail such an integrated approach to
economic history. We certainly have not put all the pieces together yet. For example, Robert
Fogel’s path breaking work on demographic theory11 and its historical implications for
reevaluating past economic performance has yet to be fully integrated with institutional
analysis. The same is true for technological change. The important contributions of Nathan
Rosenberg (1976) and Joel Mokyr (1990), exploring the impetus for and consequences of
technological change have ongoing implications which need to be integrated with
institutional analysis. An essay by Wallis and North (forthcoming) is a beginning at
integrating technological and institutional analysis. But a major task of economic history is to
integrate these separate strands of research.
VII
We cannot account for the rise and decline of the Soviet Union and world communism with
the tools of neo-classical analysis, but we should with an institutional/cognitive approach to
contemporary problems of development. To do so – and to provide an analytical framework
to understand economic change – we must take into account the following implications of
this approach:
1. It is the admixture of formal rules, informal norms, and enforcement characteristics that
shapes economic performance. While the rules may be changed overnight, the informal
norms usually change only gradually. Since it is the norms that provide “legitimacy” to a set
of rules, revolutionary change is never as revolutionary as its supporters desire and
performance will be different than anticipated. And economies that adopt the formal rules of
another economy will have very different performance characteristics than the first economy
because of different informal norms and enforcement. The implication is that transferring the
formal political and economic rules of successful western market economies to Third World
and eastern European economies is not a sufficient condition for good economic
performance. Privatization is not a panacea for solving poor economic performance.

2. Polities significantly shape economic performance because they define and enforce the
economic rules. Therefore, an essential part of development policy is the creation of polities
that will create and enforce efficient property rights. However, we know very little about how
to create such polities because the new political economy (the new institutional economics
applied to politics) has been largely focused on the United States and developed polities. A
pressing research need is to model Third World and eastern European polities. However, the
foregoing analysis does have some implications:

a. Political institutions will be stable only if undergirded by organizations with a stake in their
perpetuation.

b. Both institutions and belief systems must change for successful reform since it is the
mental models of the actors that will shape choices.

c. Developing norms of behavior that will support and legitimize new rules is a lengthy
process and in the absence of such reinforcing mechanisms polities will tend to be unstable.

d. While economic growth can occur in the short run with autocratic regimes, long run
economic growth entails the development of the rule of law.

e. Informal constraints (norms, conventions and codes of conduct) favorable to growth can
sometimes produce economic growth even with unstable or adverse political rules. The key is
the degree to which such adverse rules are enforced.
3. It is adaptive rather than allocative efficiency which is the key to long run growth.
Successful political/economic systems have evolved flexible institutional structures that can
survive the shocks and changes that are a part of successful evolution. But these systems have
been a product of long gestation. We do not know how to create adaptive efficiency in the
short run.

We have just set out on the long road to achieving an understanding of economic
performance through time. The ongoing research embodying new hypotheses confronting
historical evidence not only will create an analytical framework enabling us to understand
economic change through time; in the process it will enrich economic theory enabling it to
deal effectively with a wide range of contemporary issues currently beyond its ken. The
promise is there. The recognition of that promise by the Nobel Committee should be the
essential spur to move us on down that road.

1. In fact such a theory is unlikely. I refer the reader to Frank Hahn’s prediction about the future of
economic theory (Hahn, 1991).
2. These two sections briefly summarize material contained in North (1990a).
3. See the author’s “A Transaction Cost Theory of Politics” for a transaction cost approach to the
relative inefficiency of political markets (North, 1990b).
4. However, see the anomalies even here in the studies by Kahneman, Tversky and others (Hogarth
and Reder, 1986).
5. See Holland et al. (1986) for an excellent introduction to the cognitive science literature.
6. Ideologies are shared frameworks of mental models that groups of individuals possess that provide
both an interpretation of the environment and a prescription as to how that environment should be
ordered.
7. Ronald Heiner (1983) in a path-breaking article not only made the connection between the mental
capacities of humans and the external environment but suggested the implications for arresting
economic progress.
8. See North and Thomas (1973), Jones (1981), Rosenberg and Birdzell (1986) for accounts of this
growth.
9. See North (1990a) Part III for a brief discussion of the contrasting paths of The Netherlands and
England on the one hand and Spain on the other.
10. DeVries (1976) has a description of the bizarre remedies proposed by a Royal Commission to
reverse Spain’s decline (p.28).
11. See Fogel’s accompanying Nobel lecture.

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* I am indebted to Robert Bates, Lee and Alexandra Benham, Avner Greif, Margaret Levi, Randy
Nielsen, John Nye, Jean-Laurent Rosenthal, Norman Schofield, and Barry Weingast for their
comments on an earlier draft and to Elisabeth Case for editing this essay.