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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







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:







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







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







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







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-







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







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.







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-







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







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.







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








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.







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.








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.







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.







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







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







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

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