The Adam Smith address: economic theory in a dynamic economic world

by Douglass C. North

FORMAL ECONOMIC theory has become increasingly mathematical, elegant, and precise. It also increasingly has failed to confront the economic problems of societies. Economics, in consequence, is slowly and painfully moving away from the formal mathematical models built around a frictionless, static conceptual structure. Frank Hahn, one of the pioneers of general equilibrium theory expressed it succinctly:

"...there will be an increasing realization by theorists that radical changes in questions and methods are required if we are to deliver, not practical, but theoretically useful results." (Hahn, 1991, 47)

It is not as clear where economics is going. But the direction is suggested by two glaring shortcomings of neoclassical theory: it is a frictionless theory inn world in which the frictions are where the action is, and it is static in a world in which dynamic change is going on at an unprecedented rate. Remedying these defects requires that economics builds on its strengths, modifies the unrealistic assumptions that made it frictionless, and incorporates time into the analysis to confront the issues of economic change.

The strength of neoclassical theory has been its uncompromising focus on scarcity and hence competition as the key to economics and its power as an economic way of reasoning, evinced in microeconomic theory. Its most unrealistic assumption, which underlies its frictionless character, has been the rationality assumption. Finally, time is the dimension in which human learning, the most important source of long-run economic change, occurs.

THE RATIONALITY ASSUMPTION

The rational choice framework assumes that individuals know what is in their self interest and act accordingly. That may be correct for individuals making choices in the highly developed markets of modern economies, but it is patently false in making choices under conditions of uncertainty -- the conditions that characterize most of the crucial economic and political decisions that shaped (and continue to shape) economic change.

Herbert Simon has stated the issue clearly:

If...we accept the proposition that both the knowledge and the computational power of the decisionmaker are severely limited, then we must distinguish between the real world and the actor's perception of it and reasoning about it. That is to say we must construct a theory (and test it empirically) of the process of decision. Our theory must include not only the reasoning processes but also the processes that generated the actor's subjective representation of the decision problem, his or her frame. (Simon 1986 210-211)

But just what determines the actor's perception of the world and reasoning about it? That they vary between, say, a communist party official in the former Soviet Union, a Papuan tribesman, and a business woman in the United States is obvious; more important for us is that, faced with identical problems, these actors would frequently make different choices. The key to their differential perceptions is the kind of learning that the individuals in a society acquire through time. Here I do not refer simply to the learning and experiences of an individual over his/her lifetime but the cumulative experiences of past generations that are embodied in culture. Collective learning (Hayek's term) consists of those "kinds of learning" that have passed the slow test of time and in consequence have become embedded in our language, institutions, technology, and ways of doing things. It is culture that provides the key to path dependence -- the powerful influence of the past on the present and future. The current learning of any generation takes place within the context of the perceptions derived from collective learning, i.e., the learning process appears to be a function of the way in which a given belief structure filters the information derived from experiences and the different experiences confronting individuals and societies at different times.

How do the modification of the rationality assumption and the incorporation of time into our framework alter economics? Modification of the rationality assumption means that ideas, dogmas, prejudices, and ideologies matter. It means that the actors making decisions in the face of the uncertainty that characterizes major political and economic choices frequently are doing so with results that are widely at variance with intentions. And specifically it means that we must incorporate into our analysis the belief systems that the actors hold that determine the choices they make. And that brings us to time and human learning.

Time in this context consists of both the past experiences embodied in collective learning and the current learning experiences of individuals. Learning, then, is a cumulative process of cultural conditioning in which the experiences of each generation are filtered through the existing belief system and result in its incremental modification.

DYNAMIC CHANGE

The source of dynamic economic change is the second economic revolution -- a revolution we are still attempting to assimilate. That revolution is the wedding of science and technology, which is the underlying determinant of modern productivity. It is a revolution because it is a fundamental change in the stock (and flow) of knowledge, which entails an equally fundamental change in the organization of human beings and the structure of societies.

The development of the disciplines of physics, chemistry, biology, and genetics is the source of the growth in the stock of scientific knowledge. The systematic application of these disciplines to the basic economic problem of scarcity has not only purged the Malthusian spectre of diminishing returns from our purview but has created the vision of a potential world of plenty. To achieve that potential, however, entails a restructuring of economic, social, and political institutions and organizations in order to realize the increasing returns attributes of the technology in which this scientific knowledge is embodied.(1)

The technology requires occupational and territorial specialization on an unprecedented scale, and in consequence the number of exchanges grows exponentially. In order to realize the gains from the productive potential associated with a technology of increasing returns, one has to invest enormous resources in transacting. In the United States, for example, the labor force grew from 29 million to 80 million between 1900 and 1970; during that period production workers grew from 10 million to 29 million, while white collar workers (the great majority of whom are engaged in transacting) increased from 5 million to 38 million. The transaction sector (that part of transaction costs that goes through the market and therefore can be measured) in the United States in 1970 made up 45 percent of GNP (Wallis and North, 1986).

The transaction sector has been (and still is) growing because of the increasing costs of coordination and enforcement. Necessary to be able to realize the gains of a world of specialization are control over quality in the lengthening production chain and a solution to the problems of increasingly costly principal/agent relationships. Much technology, indeed, is designed to reduce transaction costs by substituting capital for labor, or by reducing the degrees of freedom of the worker in the production process and by automatically measuring the quality of intermediate goods. An underlying problem is that of measuring inputs and outputs so that one can ascertain the contribution of individual factors and the output at successive stages of production. For inputs there is no agreed-upon measure of the contribution of an individual input. Equally there is room for conflict over the consequent payment to factors of production. For output, not only is there residual unpriced output, i.e., waste and pollutants, but also there are complicated costs of specifying the desired properties of the goods and services produced at each stage in the production process.