The Importance of Douglass North

 

I just listened to an episode Econ Roots, in which Mike Munger was interviewed about the importance of Douglass C. North. Like myself, Munger went to Washington University and worked with North. His answer to why North was important was that “he had a view of economic history that took time seriously.” He notes, for example, that North would ask about where preferences came from rather than taking them as given.

It is a great podcast episode, but my personal answer to the question would be slightly different because I had recognized the importance of explain changes in institution over time before I read North. As an undergraduate at the The Evergreen State College the two books that had the biggest impact on me were Samuelson’s Economics and Thorstein Veblen’s Theory of the Leisure Class.

The neo-classical economics of Samuelson immediately made sense to me. I found the use of models to analyze individuals maximizing subject to constraints and interacting with other people doing the same to be an incredibly powerful tool.

Then I read Veblen. Veblen argued that economic theory was fine as far as it went, but it didn’t go far enough. In his first book, The Theory of The Leisure Class (1899), he explained that, "The institutions are, in substance, prevalent habits of thought with respect to particular relations and to particular functions of the individual and of the community: and the scheme of life, which is made up of the aggregate of institutions in force at a given point in the development of any society, may on the psychological side be broadly characterized as a prevalent spiritual attitude, or theory of life." (Veblen 1912, 190) Thus, “the evolution of society is substantially a process of mental adaption on the part of individuals under the stress of circumstances which will no longer tolerate habits of thought formed under and conforming to circumstances in the past." (Veblen 1912, 192) To Veblen this process of cultural change should be the central concern of economists: He argued that both the preferences and constraints that economic theory takes as given change over time and answering the biggest questions in economics requires understanding how they change over time.

So, I was persuaded of both the utility of economic theory and the need to explain how the things that influences those choices, including preferences, change over time.

I know that Doug read Veblen when he was younger, but I don’t think he was influenced by him, at least consciously. I don’t know if he ever read Samuelson. Yet what North provided me was a link between institutional change and economic theory. And the link ran in both directions. He provided an approach that made it possible to talk about the impact of institutions on market performance and to use economic theory to try to understand how institutions changed. The idea of transaction costs provided a means to connect different institutional arrangements to the performance of markets. Transactions costs create a wedge between buyers and sellers. The more resources you must use trying to enforce agreements or protect your property the less mutually beneficial trades will exist. Effective institutions can lower the cost of transactions, encouraging trade, investment, and innovation.  Economic models can also be used to try to explain differences in institutions and how they change over time. The first thing I read by North was a “Framework for Analyzing the State in Economic History,” followed immediately by Structure and Change. In both he used a simple model of a wealth maximizing ruler to explain institutions that do not maximize economic output. He asked why wealth maximizing ruler might not create rules that maximized output for the country, creating the largest possible pool of wealth to extract revenue from. The answer in this model was that the ruler faced a transaction cost constraint and a competition constraint. The wealth maximizing institutions might entail higher costs of collecting taxes than institutions that lead to lower levels of output. For instance, selling a monopoly might be an easy way to raise revenue but not one that is likely to maximize output. This is the transaction cost constraint. The competition constraint arises from the fact that wealth maximizing institutions might be ones that enhance the power of potential competitors to the ruler. For instance, international trade might increase output but also increase the wealth and power of people who present a potential threat to the ruler.

For me, Doug’s work meant that I didn’t have to choose between Samuelson and Veblen.

 

North, Douglass C. "A framework for analyzing the state in economic history." Explorations in economic history 16, no. 3 (1979): 249.

North, Douglass Cecil. Structure and change in economic history. Norton, 1981.

How I Built This, Entrepreneurs, and Luck

 

Guy Raz has been doing the How I Built This podcast for a while, but I only recently started listening to it. On each episode he talks with someone who built a company: Lululemon, Eileen Fisher, Jet Blue, Sierra Nevada, Uncle Nearest Whiskey, Five Guys, etc. One of the things I like about the show is that at the end of the show he always asks them how much of their success was due to their hard work and how much to luck. Most of them attribute a lot of their success to luck.

 

Chip Wilson the founder of Lululemon noted that at one point failure was only averted because another company he was working for was bought out and he received a severance package that enabled them to make payroll. He also gave an interesting answer at the end when asked about the role of luck. His answer was essentially that he was lucky that the world was ready for what he was passionate about: athletic wear that was both functional and attractive. His first venture in clothing design was comfortable shorts for himself. The story makes clear that he gave some thought and did a little research before directing that passion toward yoga, but in the end, he makes it sound like he would have continued working on athletic wear even if his success had been less spectacular.

 

It reminds me of one of my favorite papers on entrepreneurship: John Vincent Nye. "Lucky fools and cautious businessmen: on entrepreneurship and the measurement of entrepreneurial failure." Research in Economic History 6 (1991): 131-152. John was one of my professors at Washington University and this paper was published in a special issue of Research in Economic History in honor of Jonathan Hughes, author of the Vital Few: The Entrepreneur and American Economic Progress and one of John’s professors at Northwestern. John argues that we should view of entrepreneurs not as especially insightful or risk taking but as overly optimistic people who occasionally get lucky and hit on something really profitable:

 

 

 

After years of writing about business history and financial failure this is still the way it looks to me. A lot of people think they have great ideas that make them underestimate the risk of their venture. Most often they are wrong, but every occasionally someone is right. People then have tendency to attribute their success to something special about the person, despite the fact that many of them failed repeatedly. Ford is probably the classic example both because of the bankruptcy of his first company and because of some of his spectacularly bad choices after the Model T.

Theory and Experiments

 

This post was prompted by the most recent episode of Hidden Brain Putting Our Assumptions to the Test in which Shankar Vedantam talked to Abhijit Banerjee about the use of experiments in economics, specifically randomized controlled trials RCTs to study development economics.  I like the Hidden Brain, and I always enjoy listening to Banerjee. There was, however, one thing about the episode that bothered me. I thought Vedantam made it sound like Banerjee's work reflected a contest between theory and experiment, rather than emphasizing the importance of both.

The problem with this approach was most glaring when they talked about an experiment that Banerjee conducted in India to study policies to encourage vaccination. They first discussed a number of relatively unsuccessful interventions that had been made to encourage vaccination. Then they turned to Banerjee’s successful experiment. Families were randomly selected to receive an offer of a bag of lentils (1 kilo) if they got their children vaccinated. Families that received the offer were significantly more likely to have their children vaccinated. Vedantam stated that they had gained this knowledge from an experiment, not a grand theory about why poor people do not get vaccinated. But there was a grand theory, and it was clear when Banerjee talked about why it worked. He pointed out that going to get vaccinated had significant costs in terms of time and effort, and the usual unpleasantness of having small children vaccinated. The lentils, while seemingly a small thing relative to not having your children get sick, provided an immediate observable benefit to help compensate for those costs. The grand theory is that people make choices by weighing the costs and benefits. If you increase the benefits of something people will be more likely to do it. If you increase the costs, they will be less likely to do it.

In randomized controlled trials the selection of who will receive the treatment is random; the selection of the treatment is not random. Banerjee did not randomly assign people to a group that would have people pray for them to get vaccinated or to a group that would not receive prayer. He randomly assigned them to a group that would receive an incentive to get vaccinations or to a group that would not receive the incentive. The experiment was based on the theory that increasing the benefits of vaccination would make people more likely to get their children vaccinated.

Vendantam several times made comparisons to the use of RCTs in medicine and the advances in medical knowledge arising from them. But the situation is no different in medicine. People do not go to the expense of running an RCT on randomly selected drugs, nutrients, activities, etc. They have selected a treatment based upon some theory that suggests that it might work. A science with experiments absent any theory would not be possible. There are too many possible treatments.

Although the discussion on the podcast was about experiments, the argument that some theory is necessary to guide the empirical research applies to other kinds of empirical research as well. There is too much data in the world to not have some means of identifying what is useful.