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7/18/2019 Davis and North - 1970 - Institutional Change and American Economic Growth.pdf
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Cambridge University Press and Economic History Association are collaborating with JSTOR to digitize, preserve and extend
access to The Journal of Economic History.
http://www.jstor.org
Economic History ssociation
Institutional Change and American Economic Growth: A First Step Towards a Theory of
Institutional InnovationAuthor(s): Lance Davis and Douglass NorthSource: The Journal of Economic History, Vol. 30, No. 1, The Tasks of Economic History (Mar.,
1970), pp. 131-149Published by: on behalf of theCambridge University Press Economic History AssociationStable URL: http://www.jstor.org/stable/2116728Accessed: 20-03-2015 22:24 UTC
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Institutional hange and American conomic
Growth:A FirstStep Towards Theory
of Institutionalnnovation
INTRODUCTION
THIS
paper ttemptso provide n explanationftheformation
and mutationof economic institutions.t is specifically on-
cerned with that process as it has developed over the past one
hundred and seventy-fiveears of Americanhistory, ut with ap-
propriate hanges the model mightbe used to predict nstitutional
change in the future nd to explain institutional hange in other
nations nd in other ras.' Like more traditional heory, he model
has been formulatedn a manner hat makes it in principleoper-
ational, althoughwe admit that it predictsrelatively ittle.
Profit
maximization s the motivating orce, and in this sense too the
model fits nto the stream f neo-classical conomics,
lthough
ike
the macro models of Keynes ts subject has not traditionally
een
considered a part of that discipline. Finally,
we
admit that
the
theory s
at some
points woefullyweak
and
the
explanations
t
times ncredibly implistic. he work,however,does,
we
feel,
re-
present first tep towards usefultheory f
nstitutional
hange.
Historianshave
traditionally isplayed
an
interest n
the insti-
tutions
withinwhich
human
action occurs and much
of
their
work
has
involved
n
examination
f
the
interaction etween
people
and
these nstitutions.conomic historians, specially
the
new group,
have,
on
the
other
hand,
focused
heir
fforts
n
economically
ation-
al
behavior
s
an
explanation
f
past events;
nstitutions
ave
been
taken as
given,
and the
antiquarian
nterests f the more
tradi-
tional historians
ave
sometimes een
scorned.
Perhaps
because
of
their oncern
with
ong-run hange,
traditional
istorians ave
rec-
This essay
s
a
drastic ondensationf
a
forthcoming
ook
by
the
authors.We
are
indebted o Stanley ngerman orvaluable comments n an earlier raft.
1
This paper draws heavily
on the
work
of
J.
Buchanan and G.
Tullock,
The
Calculus of Consent Ann Arbor:Univ. of MichiganPress, 1962); K. Arrow, Pol-
itical and EconomicEvaluations f Social Effect nd Externaltiies, aper given at
the NBER Conference n the Economics of Public Output, April 1968; and A.
Downs,
An
Economic
Theorq
of
Democracy
New York: Harper, 957).
131
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132
Lance Davis;
Douglass
North
ognized that nstitutions
o have
something o do with
the speed
and pattern f economic
growth a
relationship hatwas obvious to
them utone thateconomists ave onlygradually erceived).Much
of
historywriting
s
devoted to the
study of the evolution
and
development fpolitical,
military, nd
social
institutions;
nd
just
as thesesophisticated
nstitutions ave
evolved through istory,
o
have complex
economic
nstitutionsmerged to
provide a part of
the
framework
ithinwhich
a highly echnical ociety
an survive
and flourish.While there re
few pieces of
history hatdo not lean
heavily upon
some
formof
theory,
here
has
been, unfortunately,
little theoryto help understandthe phenomenaof institutional
change. In
the absence
of such
theory,
istory
s
limited
to
nar-
ration,
lassification,nd
description. here are
relatively ew his-
torianswho would
willingly
ccept
such a limitation.
If our
model
of
institutional
nnovation
s
to be of any use, it
mustbe able to
predict wo
kinds
of
things: 1) Given
any estab-
lished set of
institutionsnd some
disequilibratingorce, he model
ought
to
predict
whether
he
newly
emerging nstitutions
ill be
purely ndividual, nvolvesome formof voluntary ooperation, r
relyon
the coercive
power
of
government; 2)
It
should
provide
some
estimate
f
the
period
of
timethat
s
likely
o
elapse between
the
initiating isequilibrium
nd
the establishment f
thenew (or
mutated)
institutions.
A THEORY OF
INSTITUTIONAL INNOVATION
Although heterm institution as been a partof thevocabulary
of
both economists
nd historians or
t
least
a
century,
t has never
been
clearly
defined.
At
one
time
or another t has
been
used to
refer o organizations
a
bank,
for
example,
s a
financial nstitu-
tion),
to
the fundamental
egal
rules
that
govern
the
economic re-
lations
between
people (the
institution
f
private
property), o
a
person
or a
position
(the
president
or
presidency),
and
even at
times
to
something
s
slight
as
a
particular
document
(the May-
flower ompact). We recognizethat each of thesesubjectsrelates
in some way to
the
general
types
of
institutions,
ut to avoid
confusion
t
appears
mostreasonableto
set
our
analysis
n
terms
f
the
sub-institutional
ategories-and
to
reserve he
term
institu-
tion
for
titles,
ntroductions
nd
conclusions.
n this
spirit
et
us
define:
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Institutional
nnovation
133
1. The
Institutionalnvironment
s a set of
fundamental
olit-
ical, ocial,
nd egal
groundules hat
overn
conomicnd
political
activityrulesgoverninglections,ropertyights,nd the rights
of contract
re examples
f
theseground
ules). We do
not deny
that
these
rules do change,
hat
the changes
lter the
shapeof
institutional
nnovation,
hat anygeneral
model
of institutional
change
hould redictuch
changes
n
the environment;
owever,
we
make o attempt
o explain
hem nd assume
hatwhile ffecting
the predictions
f the model
they
re exogenous
o that
model.
2.
An
nstitutionalrrangement
s an arrangement
etween
co-
nomic nits hat overn heways nwhich hese nits ancooperate
or compete.
he institutional
rrangement
s
probably
he
closest
counterpart
o
themost
widely
sed
definitionf
the term
nstitu-
tion.
hearrangements
ay e formalr
nformal,hey
may nvolve
an organization
r
not,
nd theymay
be temporary
r long ived.
The innovation
f
a
newarrangement
ill
alter
he way
that co-
nomic
nits an cooperate
rcompete, ut
the
changemay nvolve
a
single
ndividual, group
f
individuals
oluntarilyooperating
together,r thegovernmentaloneorin cooperation ithoneor
more
ndividuals).
he
latter
nnovation,
fcourse,
nvolves
ome
legal
change,
ut
the
former
ypes,
hile
esting
n
the
egal
struc-
ture
hat onstitutes
he
nvironment,
nvolve
nly
he
private
ector
directly.
t
is
the
process
f
innovationf
these nstitutional
r-
rangements
hat
he
model
s
designed
o
predict-specifically
heir
level
(individual,
oluntary ooperative,
r
governmental),
nd
their iming.
3. An ActionGroup s a decision-makingnitwhosedecisions
govern
his
process
f
innovation.
he unit
may
be
a
single
ndi-
vidual
or
a
group
f
individuals,
ut
it is
the
action
group
hat
recognized
ome
potential
ncome hat
hey
ould
receive
f
only
they
could
alterthe
institutional
tructure.
hey are,
of course,
a
subgroup
f
Schumpeter's
nnovating
ntrepreneurs,
nd
within
the
model
t s
they
who
nitiate he
process
f
arrangemental
nno-
vation.
he
action
group
lways
eceives
portion
f the
ncome,
iftheirnnovations a success.Theyalso haveto pay at leasta
portion
f the costs
of
innovation,
ut
theymay
not have
to
pay
the
operating
osts
f the
new
arrangement
if
there re
any).
4.
A
Secondary
ction
Group
s
a
decision-making
nit hathas
been
established
or
whose
ctivities
avebeen
modified) y
some
change
n
the
nstitutional
rrangement
o
help
effecthe
capture
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134 Lance Davis; Douglass North
of
incomefor the
action
group.This groupmakes the tactical
decisions hat
bring bout
the
capture, ut t does not accrueall
of that ncome it may, n fact, ccruenone).
5.
An
nstitutionalnstruments a documentr device mployed
by
an
action r
a
secondary
ction
group o effect he capture f
the external
ncome
when appliedwithin he new arrangemental
structure.
Thesefive hould e keptdistinctnd separate or heremainder
of
our
discussion.
ome
additionalncome
s
seen
by the primary
action
roup; hey,
n
turn,
nnovate
new rrangement;nd within
that tructure,ither irectly hroughheapplication f an insti-
tutionalnstrument
r
through
he creation
f a secondary ction
group nd thatgroup's pplication fthe nstrument,hecapture s
effected.
Institutionalearrangemento capture externalncome as come
from ive ources.
he
first
our
have
the
common ropertyhat
the
nstitutionalearrangement
hat
ffects
heir apture an lead
to
an
increase
n
total
ncome o
(in theory
t
least)
the
action
group an be made better ffwithout nyonehavingbeen made
worse
ff
in fact, owever,
here re
usually
edistributive
ffects).
Finally,we
are
concerned ith
certain
et
of
changes usually
n
the nstitutional
nvironment)
hatmake
t
possible
for
someone
to innovate
ew
arrangements
hat
permit
ncome
o
be
redistrib-
uted.
n
these
ases,
however,
ince here
as
been no increase
n
total
ncome,
omeone
or
some
group)
s
worse ff,
f
the
nnova-
tion
s
successful.he
four ources
f
greater
otal
ncome
nclude:
1. Economiesof Scale in productionre technological he-
nomena nd yield owerper
unit
costs
s
the scale of
production
increases,
ut
the
capture
fthese conomies
may
nvolve levelof
output
much
arger
r more
omplex
han
an be
underwritten
y
a
simple
form
f business
rganization.
n this
case institutional
rearrangementsay
nvolve
more
omplex
orm
f
business
r-
ganization
r one
with
legalrights
ot
vailable o the
proprietor-
ship.
2. Externalitiesxistwhenthe economic nit that s charged
with
making production
r
consumption
ecision s not
forced o
bear
all
the
osts rdoes
not ccrue
ll
the
revenues rom hat
eci-
sion.
f theunit
ees
greater
evenues
han
osts ven
hough
t
fails
to
recognize
ll
revenues,
r if t sees costs
greater
han
revenues
evenwithout
he nclusion
f heunaccounted
osts,
he
xistence
f
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Institutionalnnovation 135
externalities ay cause no problems.f, however,
he
opposite
holds, heunit
will lwaysmake hewrong ecision rom he ocial
point fview;and total ncomewouldalways e increasedf that
decision
were
changed n a
fashion
onsistent ith maximizing
total ncome.
ven
in
the first ase, f the externalityas yielded
an economic
nitof non-optimalize, ncome an be increased y
an
appropriateeighing f all costs nd revenues.
The history f
the
western ailroadsn the nineteenthentury
providesnexcellentxample f uch n externality.ailroads ere
sub'
ect
to
some
economies f scale; they epresentedhe east
ex-
pensivemodeoftransportor ulky griculturalommodities;nd
they id notown
ll the and along heir ights f way.As a result,
thedecisions ftherailroadmanagement ight ield smallerhan
optimum
evel
of
railroad onstruction.
In
the
American est
the
railroads
ould not practice erfect
pricedescrimination),he andownerslosest o therailroad ould
havefound heir
andrisingn valuemore han heiressfortunately
located
neighbors,nd,
to
this
extent, part
of
the
profits
rom
therailroad ccruednot to therailroad ut to thosefortunately
placedfarmers. ithin hecontext fexistingnstitutionalrrange-
ments, he
railroad's
management ay
have
chosennot to build,
sincetheywere
forced o
pay
all
of
the
costs
and
they
did
not
accrue
ll
oftherevenues.
otal
ncome
would
have
beeen ncreased
if some nstitutionalrrangementould
have been
effected
hat
would
permit
he
transfer
f a
portion
fthetotal ncome
rom
he
well
ocated armers
o the
railroads.
3. Risk-the nabilityo exactly redict heoutcome fan event
-and
a
widespread
version
o
such
risk, an
also
distortconomic
decisions,
nd lead
to less than
maximum
otal ncome.
It
is a
fact
of life that
most
persons
re
risk
verters.n the
absence
of
risk
version,
n individual
ould
be
as
willing o risk
a
dollar
or
possible
eturnf
a
millionf
the
odds
were million
to
one
as
he
would
o
risk
dollar
or
potential rofitf a dollar
when
the
outcome
s certain. n
fact,
with the
exception
f
the
very oor,most eople ppear opreferhecertain otheuncertain
outcome,
or
argegambles. f,
as
appears ikely,
isk
version
e-
comes
stronger
s the
odds
increase,
ts
presence
ends
to bias
activities
oward
hosewith
more ertain utcomes
nd
away
from
those
marked
y
a
high
variance
of
returns.
learly,
ince
the
expected
alue
of the
profits
s
higher
n
the
high
ariance
ctivities
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136
Lance
Davis; Douglass
North
that re not being
undertakenhan n the ow variance
ctivities
that re,total
profitsouldbe increasedf somemechanismould
overcome hetendency oward isk version that s, by concen-
tratingherisk mong hosewho are not averters), r by making
risky utcomes ppear
more ertain. he formerypes f
solutions
are usually
chieved hroughhe developmentf some peculative
side marketsand
are considered ereundermarket ailures), ut
the
atter
an often
e achieved hroughnsurance.
Not
all
risks re
insurable,
ut
whenthey re, nstitutionale-
organization
imed
t
innovating
nsurancechemes an
frequently
permitn increase n totalprofits.or insurance o be successful,
however, here
mustbe some basis on whichto assess the risks
accurately,nd the nsurance ase must e broad nough o permit
that herisks e spread.
The
flow
f commercend the
processes
f
capital
mobilization
and accumulation
an both be greatly acilitated y an efficient
commercial
ankingystem. n theother and, hebanks because
their ending
ctivities
re
based on fractionaleserves nd, there-
fore heir quickratios endtobe very ow liquidity) re much
more ubject
o
crises han re
most
ther
usinesses.f
crises ead
to
failure, uch
failure
an, by making eposits
nd
bank
money
appearrisky, educe
the
system'sbility
o mobilize
apital;
and
total ncome ould
be increased
f
banks
ouldbe made to
appear
less
risky.
n this ase
insuranceould
supply
he
answer,
ut such
insurance ad to
await
n
adequate mortality
able nd
an
organ-
izationwith
geographicalase wide enough
o
insure
ut from
underocalconditions.
4.
Market ailure ngendered y veryhigh informationosts
may lso
eadto
an
economic llocation
fresources-an llocation
that
ouldbe
improved
with
theconcomitant
ncrease
n total n-
come) if
some
new
arrangement
an
reduce he
costs f
that nfor-
mation.
While
conomists
end o
assume
hat ll markets
re
char-
acterized
y complete
nowledge,
n
the real
world
nformation
is
not
cost
free,
nd
therefore,erfect
markets
whose
existence
depends nperfectnowledge) o notexist. he lower hecostof
information,f course, he better
markets
will operate.
ven
in
developed
ountries, owever,
markets
re
far
from
erfect,
nd
in
an
underdevelopedountry
he
costs
f
information
ay
be so
high
that he
markets
o
not
operate
t all.
In
general,
ot
only
s
information
ostly,
ut
t
is
subject
o
in-
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Institutional
nnovation
137
creasing eturns.
hat s, one
must requently
ay
for nformation,
butthecostdoes
not
hange
muchwhether
hat nformation
s used
to effectne,onehundred, r onethousandransactions.f infor-
mation
osts
re substantial
nd if
they re subject o
decreasing
costs, t is likely
hat
ubstantial
rofitsre
to be earned
rom n-
creasingnformation
lows
nd, herefore,
educing ncertainty.
he
arrangement
nnovation
hat
s mosteconomical
will likely e
a
specialized
irmapable
of upplying
he nformation
nd
ofachiev-
ing
hepotentialconomies
fscale.
While there
s no logicalreason
to
assume hat the
high cost
of nformationight ot ead tomarket ailureven f themarket
deals onlywith
a single
ocation
nd
a
single
timeperiod,
t
is
a
fact hat
ailuremost ften
ccurs
when hemarkets
must each
across patial
r
temporal
arriers.
n the absence
of
an
adequate
information
etwork
and
other hings eing
equal)
the discounts
that
ntrepreneurs
ut
on
potential
ncome
ecause
of
the uncer-
tainty
end
to
be
higher he farther
he potential
uyer
s
(either
in
time
or space) from he
location
f the
transaction.
n
fact,
theseuncertaintyiscountsmaybe so highthat thediscounted
equilibrium
rice
maybe below
zero and
the
markets ot
operate
at
all.
Throughout
ost
f the
nineteenthentury,
here
was
an excess
demand
or inance
n
westerngriculture
s
new
ands
were pened
and
as
the
ctivity
ecame
more inance
ntensive.
ince ommercial
bankstended
o
shy away
frommortgage
oans
(in
fact,
t
was
illegal or
National
anks o
make uch
oansuntil
914)
and
since,
underanyconditions,herewas no formalmechanismo allow
eastern
anks to buy
western
mortgages
the
commercial
aper
market as
imited o
short-term
aper),
therewere
otentialrofits
that ouldbe
realized
f
some
new
arrangement
ere
to be inno-
vated
that
ould ower
he costof
uncertainty
educing
nforma-
tion
n
theeast.
Although
he
profit
oes
not
come
from
n
increase n
total n-
come,
here
re
profits
nherent
n
any
arrangemental
nnovation
that eads to a redistributionfincome. incesuccessfulapture
means loss
to
someone,
he
probabilities
hat uch
apture
an
be
effected ithout
eliance
n some
governmental
oercive
ower
re
very
mall.2
n
these
ases
t s
very
ikely
hat he
gains
anbe
cap-
2
The Mafia,
for
example,
was able to effect
n incomeredistribution
y mono-
polizing
the traffic
n some
illegal
drugs.
The
monopolization,owever,
ested
on
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138
Lance
Davis;
Douglass
North
tured
nlyby the
nnovationf an arrangement
hatputscoercive
power
n
the hands
of a governmental
econdary
ction
groupor
that ffectsenabling egislation hich ermitsomevoluntaryr
quasi-voluntary
roup
o artificially
lter he
supply f inputs r
output
f
a
good
or service.
In the purely edistributive
ase, the external
rofits
ost ften
emerge
rom ome change
n
the
institutional
nvironment.hat
change
which
s
exogenous
o the
model) might akethe
form f
an amendment
n the
constitutional
ulesgoverninghe
disposition
of
private
roperty,
t
might
eflect
n
expansion
f the
franchise,
or tmightomefrom ome hiftnthe ommunity'stilityunction
that lters heir
referencesetween
ublic
nd private olutionso
problems.
Thus,
he
adoption
f the
principle
f ndirectepresentationn
theUnited
tates enatemade
that
group articularly
usceptible
to theblandishments
f
the
obbyists
f
pecial
nterest
roups,3
nd
the
nnovation
f
protective
ariffs
an
arrangement
hat
ffected
transferf
ncome
rom
onsumer
nd
some
producers
o
manufac-
turer)was a predictableesponse. he direct lection f senators
has,
ince
913, reatly
educed
he
power
fthe
ariff
obbies, nd,
after
ome
delay,
heresult
as been
a
series
f
egislative
ctsthat
haveredistributed
ncome
n
the
opposite
irection.
On
another
evel,
he twentieth
entury
as
brought
ith t an
increased
illingness
n
the
part
fcitizens o
et
groups
with spe-
cial
competence
ontrol heirown
affairs.
ometimes
his
bias
towards
ndustrialelf-regulation
as
made
it
possible
orcertain
primaryction roupsthephysicians,or xample) ocontrol n-
trynto
ertain
ndustries,
nd,
s a
result,
o
effect
redistribution
of
ncome
way
from
he
many
owards hemembers
fthat
group.
For
example,
heAmerican
MedicalAssociation's
bility
o control
both
icensing
f
physicians
nd
the
ccreditation
fmedical
chools
has,
since hefirst ecade
ofthetwentieth
entury,
ade
ts
mem-
bers
hemost
highly aid
professionalroup
n the United
tates.
We
have
thus
ar
pecified
hesource
f the
potential
rofits
x-
ternal o theexistingrrangementaltructurendwe havedefined
some
terms
hat
we
will
use
in
our
analysis.
et
us
now
lay
out
considerable
xtra-legal
oercive
power-a
power
that s available
to
relativelyew
others
n
society.
3
On the average,
he more
ssues are involved
n
any election,
he
ess any
single
issue
will
weigh n the
mind fthe
voter.
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Institutional
nnovation
139
brieflyhe
skeleton f the model
which,
whenconjoinedwith
he
state f
the nstitutionalnvironment,
ill
(we hope) allowus
to
predictomethingboutthe eveland timingf arrangementaln-
novation.
In accordancewith
traditional
heory, ur basic
assumption
s
that he
motivatingactor n
institutional
hange s the desire
o
maximize rofits.
he
type
f
model sed
s
a variant
f
the
lagged
supply
ne frequentlymployed
n more
raditionalconomics.
n
a
lagged
upply
model, change
n
demand
n one period
f
time
produces
supply esponse
n
a later eriod
f time. n
this
model,
a changenthepotential rofitsrom rrangementalnnovationn-
duces
after omedelay or lag) the
nnovationf
a new
arrange-
ment
apable
of
capturing
hose rofits
or he
nnovators.
Assume
n
initial quilibrium.hat s,
a statewhere, iven
pre-
vailing
onditions,
o
change
n
the institutionaltructureould
yield dditionalncome
o any
ndividualr group f
ndividuals
n
the
economy.
uch a condition
ould
exist
f: (1) all potential
n-
come
ncrementsrising
rom he ources reviouslynumerated
ad
been captured yinstitutionaldjustment;rthe costsofaltering
the existing
rrangements
xceed
those
ncrements;
nd (2) there
is no change
oeffectny ncome
edistributionithout
ome hange
in
the
economic nviroment.
quilibrium
xists ut
pressure or
institutional
nnovationould
be engenderedy any
of three ypes
ofexogenous
vents:
1.
Potential
ncomefrom
rrangemental
nnovation
might
n-
crease
ecause ome
xogenoushange
ould ead to the
mergence
ofan externalityherenone existed efore,o a restructuringf
risks,
to
shift
n
transactionosts,
r to
the application
f
a
new
technologyubject
o
increasing
eturns.
2.
The
costs
of
organizingnd/or perating
new
institution
might hange
because
of
the
invention
f a
new
arrangemental
technology,
f
institutional
hange
n the
non-economicector,
r
because
the
price
of
thefactors
sed
in thenewor in
competing
existing
nstitutions
ay
change.
3. Some egalorpolitical hangemight lter he economic n-
vironment
nd
maket
possible
or ome
group
o effect
redistribu-
tion
r take
dvantage
f an
existing
xternal
rofit
pportunity.
We
assume
hat
businessmen
re
profit
aximizers,
nd
that
n-
trepreneurs
re
as
willing
o
take
dvantage
f
profitpportunities
arising
rom
nstitutional
eorganization
s
they
re
willing
o
ex-
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140 Lance
Davis; Douglass
North
ploitnew
markets,echnologiesin
the narrow ense), or changes
in
relative
actor rices. hustheprofit
otential
nherentn anyof
the hreeypes fexogenoushangeswould eadto attemptsopre-
dict not
only he evel (individual,
overnment,
r voluntaryo-
operative) f thenew
nstitution,ut
also thetime hat ne
would
expect o
elapse between he emergence
f the
profit pportunity
and the nnovation
f
thenew or themutation
f theold)
institu-
tion.
Given
heemergence
f
such profit
pportunity,
e argue
hat
the
primary
ctiongroup onsiders
rrangemental
lternatives
n
muchthesame fashion hat business irmonsidershe choice
between
alternative nvestment ecisions.Thus,
we
assume
that
the
action
group
formulates or
ach alternative
discounted
tream
f
net future
ncome ndselects he arrangemental
lternative
ith
the
highest ositivepresent
alue.
No
theory pecified
o
loosely
has
any predictive
alue,
so let
us
assume
that
he action
group's
ormulation
akesthe
following
orm:
V= -Co+ [Ri-(Cri)]
/
(1+r) + [R2-(Cr2+Cs)]/
(
l+r
2
+
...+
[Rn-(
Cr.+Cs
)]
/
(1l+r
)n
where:
V
is the discounted
present
value
of the
arrangemental
nnova-
tion
Co
is
thecost
of
effecting
he
organization
f
the
new
arrangement
R.
is
the returns hat
the
action
group
estimate
will
accrue to it
from henew arrangementnyearn
Cr.
is
the
share
of
the estimated
osts
of
operating
he
new
ar-
rangement
n
year
n
that
will
be
borne
by
the action
group
Cs
is
the
estimate
f the
costs
of
getting
tuckwith
decision
hat
the
members
f the action
group
do
not
ike. t
is
the product
of
the dollar
costs incurred
y getting
tucktimes
the
prob-
ability
hat
these
undesirable
ecisions
will be
forcedonto
them.
Hence
it s assumed
that he evel of
these
costs s
con-
stantfromyeartoyear,but thatassumption an be removed
without
materially ffecting
he
conclusions.)
Furtherwe
impose
everal
empirical
onstraints
n
the
preciseform
of the
problem.
Clearly,
he
organizational
osts
are
zero
if
the ar-
rangement
s
at
the
individual evel
and
positive
f
at
the
voluntary
cooperative
r
governmental
evel.
At the same timeCs is
zero
for
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Institutionalnnovation
141
both
ndividualnd voluntary
ooperative
rrangements,ut posi-
tive, f t
draws n thecoercive ower
f government.4
inally,we
assume hatwhile evenuesreexpected o accruen thenear uture
(in this ormulationn
year1),
stuck
osts re not ikely o arise
until ome aterdate.
As
to
the
duration f
the ag between rofitnd
innovation,
he
theory f
technical hange
uggestseveral onstraints
nd we have
incorporated
hem ntoour
model.
We assume hat
he ag willbe
shorter
hegreaterre
thenumber fknown lternative
echnologies
thatmaybe borrowed
r modified,he more olidly
re
economic
institutionsased on the egal and politicalnvironment,he arger
thenumber
fexistingrrangements
han an provide
he
basisfor
furthernstitutionalxtensions,
nd
thegreater
nd more
ertain re
thepotential
eturns.
From
thisformulation
nd
our
behavioral ssumptionf profit
maximizatione
are
able to
deduce several redictionsbout
the
nature nd timing f rrangemental
nnovation.irst, rganizational
costs lways
oom arge
ince
hey
must e metout of present ol-
lars, ut hat stuck osts re spread utover ime ndtheir resent
valuemay
not ppear ppressive
f
the
ate
f
discounts
sufficiently
large.
econd, nly hose perating
osts
orne
y
and
the
revenues
accruing o
theprimaryction roup
re
relevant
o the nvestment
decision,
nd
nnovation
s
not
desired
fno alternative
as a
positive
netpresent
alue.Third, he ime istribution
f
costs nd
revenues
is verymportant,articularly
henthe
relevant
iscount ate
s
high. ourth,
e expect hat,
f
economic
evelopmentrings
with
itdecliningapital osts, ew nnovationocapture on-redistributive
profits ill
be biasedagainstgovernment
ince the
stuck osts
delivered
n time
will
ppear arger
nd reduce he
present
alue
of
the
governmental
lternative.inally,
e
expect
hat
nnovation
ro-
ducing arger
otal ncome
will
be
made
s
soon
s
a
profitable
ech-
nology
s
available, ut
that
hose
nvolving
edistribution
ill
be
made
wiftlynly
f
he
profits
re
arge
r
the
ompetingroups
re
not venly
alanced.
THE
MODEL
APPLIED
In
the
remainder
f
this
paper
we
shall
attempt
o
demonstrate
some
f
the
promise
nd
imitations
fthe
model.
Here
we
pick
up
4
There
may
be
positive
stuck
ostsfor
voluntaryooperative
roups
f
there
re
costs
associated
with
withdrawing
rom
membership
n the
group.
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142 Lance Davis; Douglass
North
and
examine,n light
f the model,
hearrangemental
esponse o
three fthe
llustrations
n
theprevious
ection.
1. In thecase ofthewesternmortgage arket,herewere nthe
early ears
fewpeople
who
assessed he
risks ifferently
rom
he
typical
nvestornd
these ew
asternapitalists
egan o search
ut
western
mortgages.
or these
ew,
he search osts
since
they
n-
volved ending
n
agent
west) were
very igh.
Once
an agentwas
in thefield
nd had
acquired ome
knowledge f potential
nvest-
ments,t was
possible or
him o sellhis
knowledge
o
any
number
of potential
nvestors. iven
hese
conomies
f
scale, t
is
not sur-
prisinghat he nformationunctionuickly ecame nstitutional-
ized and with
hat nstitutionalization,
hecosts
f search ropped
markedly.
oreover,
nce that nstitution
ad
been established,
t
was
an
easy
step
from broker n order
o
a brokerwho
main-
tained
n
inventoryf mortgages,
nd another
imple tep
from
there
o
a
mortgage
ankwhose
ssetswere
portfolio
f
mortgages
and
who
ssued tocks nd bonds
gainst
hat
ortfolio.
he
period
of
development
eganwith
he agent
n
the ate
1860's
nd
early
1870's ndculminated ith hefirst ormalmortgageanktwenty
years
ater.
Bytheperiod
n
question,
nterest
ateshad declined ufficiently
to
makemobilizationhrough
he nterposition
f
ome overnmental
institution
ppear
ess
attractive
than
ome
private
lternative,
l-
thoughuch
government
rrangements
ad been
the innovationf
choice
orty
ears
efore hen undswere
needed or he ransport
network
n
thetrans-Appalachian
idwest. oreover,he bility o
basethenewbanking rganizationsn the tructurefagents up-
ported
y
those
astern
apitalists ith
ow
uncertainty
iscounts
certainly
educed rganizational
osts
ubstantially
nd
made
the
voluntary
ooperative
lternative
ppearparticularly
ttractive.
2. The realization
f
economies
f scale s
intimatelyonnected
with
he volution
f
he
orporation.
n
the
arly eriod
fAmerican
history
he
orporate
orm
as
associated ith emi-public
ctivities
(educational,
eligious,
nd
semi-governmental
ctivities)
ut with
thegrowingemand or arge mountsfcapital n transportation
enterprises
he
advantages
f thisform
f
organization
ed to its
rapid
doption.
nitially,
corporate
harterequired
egislativen-
actment
ut
the
growing
emand
gradually
ed to
the
passage
of
general
ncorporation
aws.
The first
uch
aw
was
enacted
n
North
Carolina
n 1795
but
diffusion as
slow
and
it
was
not until
he
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Institutionalnnovation
143
1870's hat he
ncorporationaws
ofmost tates ad beenbroadened
to permitimitediabilityndunlimited
ifespan,apitalization,
nd
purposes.
Manufacturing
nterprises erefor he mostpart
mall cale
n
the earlynineteenthentury
nd any advantages
f the corporate
formhereforeere
mall
nd outweighed
y the osts fobtaining
a charter. he
BostonManufacturingompany f
Waltham,
assa-
chusetts
as a celebrated
xception
nd ts cale ofoperation
ade
the orporateorm
f organization
referableventhough special
charter
ad to be obtained. y the
beginningfthe second
halfof
thenineteenthentury,echnologicalhangeswererapidly xpand-
ing theoptimum
ize of themanufacturingirm nd
the expansion
led to thewidespreaddoption
f the corporate
orm. here
were,
however, reat ressureso reduce
he costs f
ncorporation.
For example, he petroleum
efiningndustry
n the 1850'swas
characterized
y somethinglose
to
constant
eturnso scale. All
thatwas required o operatewas
a still basically
copperboiler
and several
hundred eet of tubing).
Small
firms
ad one still
and largerfirmsmorethanone, but costsper unit of output
werenot
function
f the
size
of
the
operation.
ver
thenext wo
decades,
however,
new
technology
as
innovated,
nd this
ech-
nologywas subject
o increasing
eturnsver wide range f out-
puts.
The new
techniques equired eryheavy
nvestmentn a
sophisticated
efininglant.
That
plant,
n
turn,
ould
produce
largevolume
f refined etroleum
uch
more
heaply hanunder
theold
technology,
ut
the
entire
lant
was
needed
that s,
t
was
indivisible )ven ftheoutputwerevery mall.As a result,arge
firmsouldproducemuchmore
heaply
han
mall, nd therewas
great ressure
or mall
firms
o
increase
heir ize. Most
efficient
firms'izes
nd thenumber
ffirms
n
the
ndustry ere,
f
course,
a
function
f
the
echnology
nd
the
relevantmarket
ize.
If
all
firms ad
equal
accessto
capital
here
wouldbe no way of
predicting hich
firms
ouldgrow
and
which
would die, nor
s
there
nyparticular
eason
o
expect
hat
eorganization
ould ring
increased rofits.n therealworld, owever,apital s notequally
available o
all
firms.
he firm's
wn
organizational
orm
may
well
be the
determining
actor
n
the
supply
f
capital
vailableto
it.
Since
both
sole
proprietorships
nd
partnerships
re
characterized
by
imited
ife
nd unlimited
iability,
he
supply
f
ong-term
x-
ternal
inance
vailableto such
firms
s
frequently
ery imited.
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144 Lance Davis; Douglass
North
Finance ends
o be scarce,
quity inance ecauseof theunlimited
liabilityttached
o such nvestments
nddebtfinance ecause
the
enterprise ay die (with tsowner) whilethe capital tillhas a
portion f its life remaining.
he latter onstraint
ecomes
more
binding hemore pecifics
thecapital.5 he
innovationfthe cor-
poration ith
tsunlimited
ife nd imitediabilityifts he
restric-
tions n obtaining
apital nd
thereforellows ts nnovators
oreap
theprofits
nherentn the conomiesfscale.
The choice fgeneralncorporation
a voluntary
ooperativeolu-
tionwhose racticalityests
n the bility o
alter tatuteaw) is an
interestingne.By the1860'snterestates ad declined ufficiently
thatgovernmental
lternativesppeared ess
attractivesomeforty
years efore
hey ad, as theexperiencef
the mixed ompanies
in Pennsylvania
nd Virginia ttest) than
the competing
rivate
forms. till pecial ncorporation
as
a
possibility,
ut
that
hoice
involved ery argeorganizational
osts.
The modelsuggests
hat
regular mall
xpenditures
imed t lobbyinghrough change
o
generalncorporationas a
less costly olution
or hesmall
manu-
facturernterestednreapinghe ncome nherentntheeconomies
of
scale. Moreover,
hatroute
permittedven this
tream
f
costs
to be shared
by the affected
irmsnd thereforehe organization
costsneed
nothave been borne
y a single
irm s
would
the
cost
of
a
special harter.
The
arrangementas
an
adaptation
f
n
already
xisting
nstitu-
tional orm,
utto effecthatnnovation
change
n
propertyights
(limitediability, aking he
orporation
legalperson,
nd
posess-
ingunlimitedifespan)was required. he institutionalnstrument
was
the
general
ncorporation
aw.
By
the
time he
petroleum
n-
dustry's
echnology
ed
to
a
dramatic
xpansion
n
plant size,
ts
organizers
ad
only
o
meet
iberal
tate
general
ncorporation
aws
to
realize
hese rganizationalenefits.
3.
Most ffortso
capture otential rofits
ia
redistribution
f n-
come
re
done
via
governmental
rganizationalorms,
nd f
volun-
tary ooperative
roup s to
succeed
n
redistributingncome
n its
favor,tmust fnecessityave somedegree fcoercive uthorityo
limit upply-an authority
hat lmost
lways
must
ely
n
govern-
ment
iat.
he
history
fthe
American
edicalAssociations
an ex-
5
If the
finance
s investedn capitalforwhich here
s
a
readymarket,
he prob-
lems existbut their
ffects minimized.
f, however, he capital has no
market, he
demise f theowner
may ignal hedefault f the oan.
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Institutionalnnovation
145
cellent xample f
voluntaryooperativeroup cting hroughhe
governmento uccessfully
edistributencomen tsfavor. he
AMA
was founded n 1847 and adopted two basic policy positions:
(1) thatdoctors hould
e licensed; nd
(2) that chools fmed-
icinemust e accredited. tate egislatures
ererapidly onvinced
to
license hepractice
f medicine, ut the success f the second
objectivewas notachieved ntil he AMA
set up the Council
on
Medical ducation
nd that ouncil n turn
ersuaded heCarnegie
Foundation o do
a joint tudy f medicine
n the UnitedStates.
The Flexner-Colwell
eport,
ublishedn
1910, ecommended
hat
substantialumberfmedical chools e closed, tandardseraised,
and admissionsharply
urtailed.6lexner's
iewthat herewas an
oversupply
f
doctors
nd that
there houldbe fewer ut
better
trained octors as
widely ccepted y
state egislaturesnd these
bodies
n
turn
elegated o
the
AMA thetaskof
determininghat
was
or
was
not first
lass
medical
chool. tate tandards orwin-
ning license o practicemedicineimited
pplicants o graduates
of
thesemedical
chools.The
number
f medical
chools
was
re-
ducedfrom 62 n1906to69 in1944, henumberf medical tu-
dents
rom
8,000
n
1904
to
14,000
n
1920.
The
latter
igure
id
notreach he1904total gainuntil he
mid
1950's.)
As a
result,
he
number fdoctorser 100,000 opulation
ropped
rom 57
n
1900
to
132
n
1957.
ncomedata
for
he
medical
rofessionnly
begins
in 1929but even
n that
eriod
he
figures
ttest o
theAMA's uc-
cess.
For the
years
939
hrough
951 he
mean
ncome f
physicians
increased 18 percent-a
figure
hat s 42
percentmore han he
n-
crease or entists,13percentmore han orawyers,nd132per-
cent
more hanfor
managers
nd
proprietors.7
In terms
f
our
model,
he ction
roup
was
theAMA.
The insti-
tutional earrangementequired olitical
ction
y
state
egislatures
to
enact
icensing
equirements
nd to
delegate icensing
uthority
to state oards
ffiliated
ith
he
AMA. The stateboards
were
the
secondary
ction
group
nd
the nstitutional
nstruments
mployed
to effect
hese
olicies
were
he
icensing
aws
and
policies.
In termsf themodel, he nitial rganizationosts ftheAMA
in themid-nineteenth
entury
ere
educed
ecause
he
Association
8
R.
Kessel,
Price Discrimination
n
Medicine, Journal f
Law and
Economics,
I, No. 1,
26.
7
Data
from
Elton Royack,
Professional
ower and
American
Medicine
(Cleve-
land: World
Publishing o.,
1967), chs.3
and 4.
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146 Lance Davis;
Douglass
North
could offerxclusive enefitsthat s, malpracticensurance) ot
available o outsiders.rom his rganizationalase the passionate
minority ith pecific oals was able to convince olitical odies
to innovate new nstitutionalrrangement:ndustryself-regula.
tion.
CHANGES IN
THE
PUBLIC-PRIVATE
MIX
We feel
hat
ur study heds ome lluminationpon
one
mpor-
tant
uestion n American conomic istory-the hanging ublic-
private conomicmix.While ome f the ources f this hange re
exogenouso ourmodel, hat s, they re engenderedy changesn
the basic institutionalnvironment,ur modeldoes suggestwhat
theconsequencesfthose hanges avebeen n terms
fthe
partic-
ipation f government
n
economic ctivity. ther
ources f those
changes
re
theresults f theprocess f arrangementalnnovation,
and thusour modelhas some direct mplicationsbout the
mix.
In
this
ectionwe shallvery rieflyummarize
he sources
f
the
basic
trends,nd suggest ow they
ave affected
he
public-private
mix.
Throughhe arly ineteenthenturyhegovernmentarticipated
in a widevarietyf conomicctivities-a articipationowhich he
studies f CarterGoodrich, iltonHeath, heHandlins, nd Louis
Hartz ttest. art fthe xplanationor his articipation-a ortion
that s
exogenouso ourmodel-lies
n
thegeneral ttitude owards
governmentarticipation
hat
was
inherited
rom
he mercantilist
policies
f
the
English, heritage
hat
ccustomed
eople
to
such
intervention.owever, more asic and positive xplanations en-
dogenous-despite he existence
f some
poor administrators,
he
government
infrastructuresfthenewstateswerewelldeveloped
relativeo the ather rimitiveevelopmentffactorndcommodity
markets. s a
result,
he benefits f
usinggovernment
o
capture
somepotential rofitsparticularly
n
thereduction
f
transactions
costswhen
markets
ere
small) were typically reater
han
hose
that
could be achieved through urelyvoluntary rganizations.
Moreover, hen nterestateswerehigh hepotentialosts f get-
ting
tuck id
not
appear arge.
The
decision
o
let government
underwrite
anal
nvestment
uring
he1830's
was,given heprim-
itive tate f the
American
apitalmarket, rational ne and pro-
vides
n
excellentllustration
fthis
oint.
A
dramatic ransformationook
place
in the
nineteenthentury.
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Institutional
nnovation
147
The Constitution
ith tscarefully
onstructed
rameworkfchecks
and balancesdesigned
o prevent
ny faction rom
edistributing
incomen itsfavorat least any argegroup romttemptingre-
distribution
rom he
fewto themany),
he imits
n suffragend
the nterpretations
f the Marshall-dominated
upreme
ourt,
ll
events xogenous
o our ystem,
ade effortso redistribute
ncome
more qually
very
ostly. n addition,
hepublic
attitude owards
governmentnvolvement
hanged
ollowinghewidespread
efault
of tategovernment
onds
nthewakeofthe1839-1843
epression.
This hange
n
the ommunities'tilityunction
lso
lmost ertainly
contributedo thedeclinen thereliance ngovernmentalrrange-
ments.
The
growing
ize of theAmerican
marketn thenineteenth
en-
turywas
a continuous
isequilibrating
orce hat
ed to changes
in the public-privateix.
As the market rew t created
otential
profitsor
hosewhowould
nnovatenstitutional
rrangements
o
reduce
ransaction
osts.Given he alternative
osts
nd revenues
these
new arrangements
ended o depend
heavily n voluntary
o-
operativerganizations.hedevelopmentfa multitudeforgani-
zational orms
esigned o
realize ower
nformation
osts r spread
risks
haracterizedvery
acet
of
the factor
nd
productmarkets
from
heprimitive
uction ystemssed
to
distributemports
n
the
early
ineteenth
entury
o the
ophisticated
utures arkets
n
basic
agricultural
ommodities
hat
ad
emerged y
1900.
Thetwentiethentury
as
marked
n
equally
dramatic eversal.
The basic economic
nvironment
as been altered
y delegation
f
governmentuthorityt boththe federal nd state evelto com-
missions-a
delegation
hat
has
significantly
owered he
cost
of
n-
fluencingovernmentolicy
n thebehalf
f
organized roups;
he
franchise
as been
extended
nd that
xtension
as
encouraged
f-
forts
o effect
ore
qual
income
istribution;
he decisions f
the
Supreme
ourt
particularly
ith
espect
o
ts iberal
nterpretation
of
theCommerce
lause)
has raised herevenue
rom
he
nnova-
tion
f
governmental
rrangement
n a
myriad
f
conomic
ctivities;
thedepressionf1929-1941hanged eople's asicattitudesbout
therelative
fficacy
f the
market
ersus
overnment
ntervention;
and twoworld
not
to mention
esser)
wars ncreased
overnment
influence
ver
resource
llocation
nd
that
rend
as
not been re-
versed
n the
ubsequent eriod
f
peace.
Related
o
the
process
f
development
ut
containingmplications
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148 _
Lance Davis; Douglass North
for he
mixhas
been
the
emergencef
externalities
ssociatedwith
thegrowthf
urban
gglomerationsnd
ncreasingnterdependency.
Theeconomiesf cale nherentnmodernechnologyaveproduced
an
urban
ocietyn which he
divergenceetween rivate
nd
social
costs n the rea
of
ransportation,
ollution,
nd
health
as
produced
pressing
roblems ot asily
esolved
ithouthe oercive
uthority
of
government.
tthe ame
time,
he
pecialization
f
functionhat
has
accompanied
rowth as been a
source f
mutual nterdepen-
dence.
As
a
result,
t has become
ncreasingly
pparent
hatthe
policies
f one
group ave significantelfare
ffectsn
others,
nd
thisnterweavingfdestinies as alsotended o ncrease hereliance
on
government.
To
summarize
n
more
general
erms,
he
rise of
governmentn
the
wentiethentury
tems
rom he elative
ncreasenthe profit-
ability f
attemptso
redistributencome nd
from
he
problems
associated
with
xcluding
on-participantsrom
hebenefitsr
the
costs
f the
ctivitiesf
ndividualsnd
groups
n a
society harac-
terized
y
massive
gglomeration
nd
nterdependence.
CONCLUSION
It wouldbe very
asy o fall nto he
tautologicalrap nd
argue
that
ur
theoryffers
rationalizationor ll
arrangemental
nnova-
tion;however, e have ried
o
make hemodel
perationalat
least
in
principle). n this
egard
we have
cast all costs nd
revenues
n
money rather
han
psychic)
erms,ut we
are
the first
o admit
thattheexistence funcertaintiesnd uncertaintyiscountshat
cannot e
readily
ranslated
nto
money
ermsimits
he
usefulness
of
our
model.
Moreover,
t
should e
equally
lear hat
we
have
not
been able
to
predict
verything,
nd that hetotal
icture
s
one of
something
onsiderably
ess
than
universaluccess.
The
model
appears
to
yield
results
hat
are
particularlyoor:
(1)
in
thepolitical rena
whenever he
gainsfrom
nnovation
re
small r
when
he
opposing
oalitions
ho
attempto
accrue
hese
gains rerelativelyvenly alanced; 2) inthepredictionf evell
when
he hoice etcontains
ot
only
he
hree
pure V
olutions
ut
a
large
number f
mixed
for xample,
artly
rivate,artly overn-
mental) lternatives;
nd
(3)
on the
entire
uestion f
the
nstitu-
tionalenvironment.
here
we
have
been
forced o
assume hat
changes
n that
nvironment
re
exogenous
hile
n
fact,
t
leasta
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Institutional
Innovation
149
part f
them
re
endogenous,nd
should e
soconsidered
n a more
generally
ormulated
heory.n
all
three fthese
reas
better esults
await urthermprovements.
Despite
hese
ualifications,
e argue hat
his
xercise as
been
worthwhile.t has
focused
ttentionn
theneed
for
ome heoryf
institutional
hange,
fwe are
everto
havea
useful
heory f eco-
nomic rowth,
nd,even
n its
present
rude
form, hemodel
has,
we
feel,
llowedus to
take
a
new
and productive
ook
at
certain
aspects
f
theAmerican
istorical
xperience.
LANCEDAVIS,
CalifornianstitutefTechnology
DOUGLASS
NORTH,Universityf
Washington