Central Idea: Institutions (formal rules and informal constraints), Technology and Ideology together shape economic performance, by determining the costs and benefits (so incentives) of transacting and producing. Their main function is to reduce uncertainty and frame human interaction.
In Douglas C. North's 1992 essay 'Institutions, Ideology, and Economic performance', he presents economic performance as a function of the following three factors:
Formal Institutions: The rules of the game within society. A polity can affect them with relative ease.
Informal Institutions: Customs, Culture, Traditions. Resistance to change.
Ideology: What is considered fair and desirable and what is not. What the world is and how it ought to be.
Subsequently, these factors translate into economic prosperity via their impact on market efficiency and the costliness of transactions. These are outlined below:
Market efficiency: low-cost measurement and contract enforcement, complementary informal constraints, effective enforcement, and adaptive efficiency (provides incentives for the acquisition of knowledge, innovation, encourages risk-taking and creativity). The efficiency of the markets ensures effectiveness as well as adaptability in the face of changing (due to socioeconomic and technological alterations) organizational structure. Especially important with the ever-changing world of the 21st century that challenges all existing organizational forms.
The costliness of transactions: The smaller the cost, the more likely an economy is to prosper. Pivotal for the globalized economy of our time, where prosperity depends on transactions between organizations and agents on an unprecedented scale. Furthermore, the costliness of transactions is affected by: 1) Accurately measuring the value of goods, services, and agent performance. 2) Market size. Large market size is addressed by impersonal exchange (contracts) while small market size by personal exchange (kinship ties, friendship, personal loyalty). 3) Enforcement. How justice is implemented. 4) Ideology. What people and organizations tend to think about the rules of the game.
Conclusion
In this note, North provides a more holistic approach to explain how and why economies and states rise and fall. Socioeconomic reality cannot be explained in merely economic terms. To adequately address its complexity, North structures his analysis in 3 main parts: formal and informal institutions and ideology. These factors act in a complementary way. For example, the adoption of the US constitution and market laws from South American countries has yielded suboptimal results. The way these crucial factors interact determines the costs and incentives of producing and exchanging goods and services, as well as the quality of the societal organizational structure and the efficiency of markets. In other words, the institutional along with the social-subconscious-historical layers of a society determine what makes people create, trade, and coexist efficiently or poorly.
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