Government and the Cost of Exchange in History

DOUGLASS C . NORTH A general transaction cost framework is developed to analyze the costs of exchange and the role of government in the costs of exchange. Three general types of exchange are specified: personal exchange, exchange without third-party enforcement, and exchange with third-party enforcement. The framework is then employed to analyze government and the costs of exchange in history.

N the Walrasian general equilibrium system, there are no costs to exchange and no government or any other institution except for a perfect (and costless) market. The difference between that Walrasian system and the subject matter about which we economic historians theorize concerns transaction costs. Transaction costs are the basic determinants of institutions and provide the framework within which economic activity occurs. The new (now getting old) economic historians focused on prices and changes in prices as determinants. But supply and demand functions themselves are a consequence of the market structure, which in turn is a consequence of the property rights structure. And underlying property rights and interacting with them are the costs of transacting. Intimately involved with the costs of transacting is the role of government in specifying and enforcing property rights. Our understanding of these connecting links is still in its infancy, but there can be little doubt that studying the connections will be the major theoretical focus of economic historians in the foreseeable future. Unlike the path that the new economic historians took a quarter of a century ago when they appropriated the tools of neoclassical economics and econometrics, this path is terra incognita. Now we must be theory builders, rather than just theory users. It is true that recent work in economic theory dealing with uncertainty, information costs, and transaction costs are initial building blocks; but there is a crucial distinction between the central thrust of the economist and that of the economic historian. The economist is concerned with analyzing the performance of an economy within a given set of constraints. The economic historian, by contrast, focuses on how the constraints change over time. The very definition of transaction costs we must employ

Journal of Economic History, Vol. XLIV, No. 2 (June 1984). The Economic History Association. All rights reserved. ISSN 0022-0507. The author is Henry R. Luce Professor of Law and Liberty in the Departments of Economics and History at Washington University, St. Louis, Missouri 63130.

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differs from that typically used by economists. At the same time, the application of economic theory to politics (that is, the public choice literature) is far too circumscribed an approach to the problems of the economic historian.

II

Transaction costs are the costs of specifying and enforcing the contracts that underlie exchange. They include all the costs involved in capturing the gains from trade. Whether exchange occurs across markets or as part of the production process inside firms, the resources devoted to the organization and integration of the production and marketing of goods and services are a largeand growingshare of the total costs of goods and services. Underlying these strictly economic costs are the costs of specifying and enforcing the body of property rights (as well as the costs of attempting to alter the property rights), which are a large share of the costs of government. Both the changing costs of economic organization and the changing costs of specifying and enforcing property rights must be central to the economic historian's studies. In contrast, economists typically look on transaction costs as efficient organizational solutions to the problems of production. This approach is deficient on two grounds. One, it takes the political rules of the game as givenwhen, in fact, changes in property rights are the key determinant of changes in the performance of economies. Two, it takes the choice of technique of production as givenwhen, in fact, that choice is always made relative to the transaction costs involved in employing it. Moreover, the definition I am employing here has radically different welfare implications from the more standard definition in economics. There is no implication that the results are efficient (in the Pare to sense), since we do not know how to define efficient government. I do not need to remind economic historians that there is little evidence from the past that the structure of property rights specified by governments was efficient (in the sense of promoting economic growth). Therefore, when we turn to analyzing the political process, our central concern must be to explain the characteristics of the state that result in the property rights structure and their enforcement. Such an approach of necessity is far more comprehensive than that employed in the public choice literature. In that literature the typical question is what are the consequences of a particular set of decision rules, whereas we must ask how those decision rules change over time and produce alterations in the property rights structure. Moreover, the economic approach to politics typically assumes that an interest group model of the political process will explain the outcome. But ideology matters;

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otherwise we cannot explain why politicians appeal to voters on the grounds of the fairness or justice of the rules of the game, nor why princes in the past promulgated their divine right to rule. The economist who ignores ideology must explain the immense resources expended by principals in the past, as well as in the present, in attempting to convince participants that the particular forms of political or economic organization are fair. To the degree that participants are convinced that they are fair, the costs of enforcement of both political rules and contractual arrangements in exchange are reduced. I believe there are four major variables involved in the costs of exchange. The first is the cost of measuringmeasuring the valuable attributes of the goods and services being exchanged or measuring the performance of agents. Measurement attempts to delineate precisely what the participants are exchanging or what performance characteristics are expected of agents. It is essential to the specification and enforcement of property rights and underlies all the costs of contracting. In a world of perfect and costless information, measurement would be unnecessary and there would be no transaction costs since each party already would know precisely what was being exchanged or what was the performance of agents; and enforcement would be unnecessary since both parties would costlessly know the outcome of disputes ahead of time. The immense resources that societies devote to organization and enforcement would be superfluous and the Walrasian system would indeed provide a model for the economy. But because information is costly and imperfect at best, the other three variables in the cost of transacting become important.1 The second variable is the nature of the exchange process. Personal exchange is exchange in which kinship ties, friendship, and personal loyalty all play a part in constraining the behavior of participants, or even lacking these, in which repeat dealing and personal knowledge of the other participants constrain behavior. All of these factors reduce the need for costly specification and enforcement. A handshake suffices for even complicated exchange. Absent these factors, and the exchange process becomes much more costly. In impersonal exchange there is nothing to constrain the parties from taking advantage of each other if they can gain by doing so. Accordingly, contracts must be specified as precisely as possible and elaborate safeguards developed to enforce compliance. Enforcement is the third variable. In a world of perfect enforcement there would be a neutral third party impartially evaluating disputes and awarding compensation to the party injured as a result of contract violation. In such a world, opportunism, shirking, and cheating would
1 Yoram Barzel, "Measurement Costs and the Organization of Markets," Journal of Law and Economics, 25 (April 1982), 27-48; and Douglass C. North, Structure and Change in Economic History (New York, 1981).

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never pay. But such a world does not exist because the costliness of measurement frequently makes it difficult to determine whether a contract has been violated (and by whom). Nevertheless, an impersonal body of law, courts, and the coercive power to enforce judgments are fundamental factors in permitting the complex contracting essential to a world of specialization and impersonal exchange. The first three variables determining the costs of exchange arise as a consequence of an environment in which individuals maximize at every margin. If cheating pays, one cheats; if loafing on the job is possible, one loafs; if one could with impunity burn down a competitor, one would do so. In the neoclassical world, behavior is only constrained by rules and the effectiveness of their enforcement. Although the neoclassical assumption has been a powerful tool in analyzing market exchange, it is clearly incomplete. In the context of the high costs of measuring performance, complex social organization would be impossible were everyone to murder, cheat, steal, and shirk whenever he found it profitable. Honesty, integrity, living up to the spirit as well as the letter of the law do matter. But how much? If the amount were constant over time and among individuals we could stick with the neoclassical assumption that preferences or tastes matter but are held constant. But ideological attitudes, the fourth variable, are not constant. The strength of ideology can be measured by the premium people are willing to incur rather than "free ride." Such a premium is the cost of one's convictions. Not only does the premium vary according to one's beliefs about the justice of the rules and the contractual arrangements of the society, but it can be influenced by "education," propaganda, and symbols. Appeals to justice and fairness do matter, otherwise we would be at a loss to explain a good deal of schooling as well as the immense investments made by politicians, employers, labor leaders, and others in trying to convince participants of the fairness or unfairness of a contractual arrangment. Our understanding of ideology is still sketchy, but one additional point about it appears to be significant. Specialization and division of labor produce divergent perceptions of reality and hence contrasting and conflicting views of the fairness and justice of institutional arrangements. In such a world the cost of contracting, ceteris paribus, increases because one cannot rely on common perceptions of fairness to enforce compliance of agreements. These four variables have combined to produce an enormous variety of forms of economic organization, which can be subsumed, however, under three general types: personal exchange, impersonal exchange without third-party enforcement, and impersonal exchange with thirdparty enforcement. Let me elaborate upon each of these "ideal" types. Personal exchange, characterizing small-scale production and local trade, has been the predominant form of organization throughout history. Cultural homogeneity (that is, a common set of values) and a

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lack of third-party enforcement (and indeed, little need for it) have been typical. Under these conditions transaction costs are low; but because specialization and division of labor are rudimentary, production costs are high. Impersonal exchange without third-party enforcement covers an enormous variety of types of organization, spanning relatively largescale retail (and wholesale) trading, long-distance and cross-cultural trade, and forms of organization in which one party has overwhelming coercive power relative to another. The Suq or bazaar economies illustrate the first of these. 2 The commenda and variations upon it typify the second; serfdom and slavery the third.3 In the case of the bazaar and commenda, the lack of third-party enforcement leads to elaborate efforts to establish repeat dealings and clientization, to use kinship ties, and to set the trade within the context of rituals and religious precepts in order to constrain the participants. In the case of serfdom and slavery the state must be an interested party in enforcing the terms of exchange. The three have in common high costs of transacting and limited gains from trade. Specialization and division of labor tend to be limited to the specific form of organization and a specific type of economic activity. The abstract notion of a third party impartially specifying property rights was set against the reality of very imprecise actual specification of property rights, and imperfect enforcement. Nevertheless, a society that would realize the productive benefits of great specialization can only do so with an elaborate structure of law and its enforcement. There are no cases of complex urban societies that do not have an elaborate structure of government. Impersonal exchange involves the high measurement costs of complex contracting necessary to realize the potential of the technology that comes from specialization. Neither self-enforcement by the parties themselves nor "trust" is a viable way of enforcing such contracts. It is not that ideology does not matter. It does; and as described above, immense resources are devoted to attempting to promulgate codes of conduct. But equally, the rate of return on opportunism, cheating, shirking, and so on also rises in such a context. A coercive third party is essential. One cannot have the productivity of an industrial society with political anarchy. But while such a state is a necessary condition for realizing the gains from trade, it obviously is not sufficient. A state becomes the inevitable source of struggle to take control of it in the interests of one of the parties. The state then becomes the vehicle by which the costs of transacting are raised to capture the gains that will accrue to any interested party that can control the
Clifford Geertz, Hilda Geertz, and Lawrence Rosen, "Suq: The Bazaar Economy in Sefrou," Meaning and Order in Moroccan Society (Cambridge, 1979), pp. 123-313. 3 It should be carefully noted that, because of the high costs of measurement and enforcement, the stronger party still must take into account the actions of the weaker party; hence the usefulness of this approach even with coerced agreements.
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specification and enforcement of property rights. The point has been the subject of such an extensive literature that it appears to have obscured the key point. If you want to realize the potential of modern technology you cannot do with the state, but you cannot do without it either.

If one accepts the foregoing argument, one is forced to confront what is perhaps the main question for the economic historian about the premodern world. Did the interest of state rulers coincide with a set of property rights conducive to economic growth? By and large, they did not; and where states existed they appeared to be early counterparts of the Mafia. Under those conditions exchange either was personal or impersonal without the third-party enforcement described above. The puzzle is: Why did not the rules of states foster "efficient" property rights? After all, "efficient" property rights meant more output and income and, therefore, more tax revenues and wealth for the ruler. Historians have advanced two general types of arguments. The first is that rulers were ignorant of or uninterested in such mundane issues. The second is that constraints existed such that they could not afford to develop such property rights (a wealth-maximizing argument). The first hypothesis is implicit in "social structure" analysis in which princes and aristocrats had little or no contact with peasants and had a distaste for all types of commercial activity. The argument is not necessarily inconsistent with the second hypothesis, in which rulers could not adopt efficient property rights because their adoption threatened their dominations either vis-a-vis peasants or other lords. The wealth-maximizing argument appears to be consistent with a broad range of observations about the generally inefficient character of property rights, even in the modern era when there is widespread knowledge about sources of productivity. Put in straightforward terms, rulers may be ignorant of the efficiency consequences of their rules, but even when they are knowledgeable they cannot afford efficient rules. But such an argument only brings us back to the central issue of economic history: that is, to explain how the constraints change and what particular set of constraints will result in political decision making that will foster efficiency. A change in constraints comes from a change in the relative bargaining power of rulers versus constituents (or rulers versus rulers), and, broadly speaking, changes arise because of major, persistent changes in relative prices. Efforts to recontract will occur because one party now believes he could or should do better. For the ruler there is no free-rider problem; but there is such a problem for constituents. Hence, a change in perception of the fairness of the terms will be a necessary prerequisite to action. Gradually such persistent

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efforts to recontract come up against the fundamental constitutional rules, or customs. They either are eroded away and replaced (in the case of customs) or are changed gradually or by revolution. The major sources of change in relative prices have been population change, changes in the stock of knowledge, and changes in military technology. In the case of the development of Western Europe, I have put forward what I believe to be a plausible scenario of the forces for secular change, and have explained why in the Netherlands and England there resulted a set of property rights that induced economic growth.4 But at this time our understanding of these issues is so primitive that any such argument must be regarded as only an initial stepping stone to further research.
IV

In the premodern world, economies were simple, uncomplicated organizational structures. Exchange was for most individuals, a supplement to a largely self-sufficient life. The transformation of the past halfmillenium has been to ever greater division of labor so that the selfsufficient component of every day life is negligible. If the elaborate (and costly) organizational structures that evolved with an urban society were simply dependent variables to realizing the gains from trade, then the subject of transaction costs would take the form of much of the modern literature of economists on the subject. The modern corporation could be treated as a transaction cost solution to realize the advantages of the large-scale organization associated with modern technology.5 The separation of ownership and control in the corporation could be analyzed as an efficient device to separate the decision making from the risk-bearing function, with the market for managers solving the agency problem posed by Berle and Means. 6 Similar analysis could account for the stock, commodity, and futures markets, as well as for the growing proportion of the society's resources devoted to wholesale and retail trade. Historically, the transformation of the past 150 years is a story of the "Managerial Revolution in American Business," to quote the subtitle of Alfred Chandler's study, The Visible Hand. But there is more to it than a study of efficient solutions to the problems of realizing gains from trade made possible by the revolutionary technology of the modern era. The railroad was not only the seedbed of modern business organization, it was also the seedbed of governmental regulation and a
North, Structure and Change, pp. 143-86. Oliver Williamson, "The Modern Corporation: Origins, Evolution, Attributes," The Journal of Economic Literature, 19 (Dec. 1981), 1537-68. 6 Eugene Fama and Michael Jensen, "Separation of Ownership and Control," The Journal of Law and Economics, 26 (June 1983), 327-49.
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consequent struggle over control of the regulatory machinery that specified the property rights structure. The rise of the insurance industry was an efficient adjustment to the increasing risks associated with specialization; but the control of the New York State legislature by the life insurance companies was a way of specifying a set of property rights that, among other objectives, prevented policyholders from suing the companies to demand an accounting.7 Agriculture has been the economist's model of a competitive market, but this atomistic competition has been set within a price support program, milk marketing acts, and a thousand and one other specific rules that shape the supply and demand functions that determine agricultural prices. In short, if the property rights structure is taken as given, then we may explore the way markets work. But by doing so, we will be ignoring the very essence of what modern economic history is aboutto account for the evolving structure of property rights that underlie performance. The cost of contracting in the modern world is a combination of the resources devoted to specifying, enforcing, and altering property rights and resources devoted to economic organization. Even the most casual inspection of historical statistics makes clear that both have grown enormously in the past 100 years. The cost of government has risen in total, and it has risen when transfer payments are netted out of the government statistics.8 Much of government, therefore, is really an intermediate service, rather than the final service portrayed in the national accounts. 9 So, too, are trade, finance, and banking, and much of what is included under the general rubric of services in the national accounts. Between 1869 and 1970 in the United States, employment in wholesale and retail trade grew from 7.8 percent to 19.1 percent of the
7 Douglass C. North, "Entrepreneurial Policy and Internal Organization in the Large Life Insurance Companies at the Time of the Armstrong Investigation of 1905-6," Explorations in Entrepreneurial History, 5 (Spring 1953), 139-61. 8 Douglass C. North and John Joseph Wallis, "American Government Expenditures: A Historical Perspective," American Economic Review (May 1982), 336-40. 9 Simon Kuznets, many years ago, was concerned that government was treated as a final product rather than as an intermediate good, and engaged in a lengthy discussion in the journals with Hicks and others over this issue. It is worth quoting him at some length, since he catches the flavor of the point made here. "The flow of services to individuals from the economy is a flow of economic goods produced and secured under conditions of internal peace, external safety, and legal protection of specific rights, and cannot include these very conditions as services. To include the latter implies feasibility of national income and of the flow of services to individuals outside the basic social fabric within which economic activity takes place. There is little sense in talking to individualsit is a precondition of such services, not a service in itself. . . . It is difficult to understand why the net product of the economy should include not only the flow of goods to ultimate consumers but also the increased cost of government activity necessary to maintain the social fabric within which the flow is realized." (Simon Kuznets as quoted in Paul Studenski, The Income of Nations: Theory, Measurements, and Analysis: Past and Present [New York, 1958], p. 198.) While Kuznets's quotation refers to the role of government in underpinning economic activity, there is no logical reason why this should not extend to other transaction services that are associated with capturing the gains from trade.

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labor force; finance, insurance, and real estate from 0.4 percent to 4.6 percent; and services from 11.1 percent to 17.4 percent. (During the same period, government grew from 3.5 percent to 18.1 percent.)10 The growth in the size of the transaction sector, however, is only partially accounted for by the measured growth of those services that should be considered intermediate rather than final output. An equally large, perhaps larger, growth of transacting was occurring within firms during 1869-1970specifically, the expansion of legal, accounting, personnel, and marketing departments, the major sources of growth of employment. While there is no direct measure of this change, one indirect measure can be examined by the changing composition of the basic labor force. From 1900 to 1970, the nonagricultural labor force grew from 29 million to 79 million. White-collar workers were 18 percent of that total in 1900 and 47 percent in 1970. Needless to say, this gross transformation does not directly get at the proportion of the growth in the transactions sector alone. But an inspection of the major increases among occupations in the labor force between 1900 and 1970 (as in Historical Statistics, Series D182-232) does confirm the disproportionate growth in such occupations as accountants and auditors, clerical and kindred workers, personnel and labor relations workers, and so on. Obviously, the proportion of society's resources devoted to exchange has been increasing; this is not surprising. There are three sources of the increasing size of this transaction sector. First, growing specialization and division of labor means an ever-increasing number of exchanges, each of which requires specification and enforcement, necessary whether across markets or within firms. Second, the cost per exchange tends to rise as impersonal exchange replaces personal exchange. And third, government's increasing control over property rights enables groups that acquire influence over decision-making governmental bodies to raise the cost of transacting to other parties to exchange and thereby redistribute income to themselves. There are counteracting tendencies to these three factors. The first is the innovation of organizational forms that reduce the cost of transacting. This is the focus of Williamson's study of the corporation (1981) and of much of the economists' transaction cost literature. The second is the substitution of capital for labor to reduce the opportunity for shirking, stealing, and opportunistic behavior and to reduce quality variance.11 Finally, the role of government has not been simply a gigantic mechanism for income redistribution, raising the costs of transacting. As the foregoing has attempted to argue, the role of government as an
10 U.S. Department of Commerce, Historical Statistics of the United States (Washington, D.C., 1975), p. 139. 11 A substantial part of technological change has had this objective in the past century.

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impersonal third party to specify and enforce contracts has been an essential part of the story. One has only to contrast the role of government in advanced Western countries with that in Third World countries to appreciate the gulf that separates them in the specification and enforcement of property rights. In the Third World the government still resembles the Mafia and exchange is accordingly limited as described above. In the West the role of government is fundamentally conditioned by an ideological conviction about the value of the rules that does constrain the participants (however imperfectly). We are a long way from understanding ideology's role in the stability of and change in institutions; but ideology is clearly a critical determinant to understanding the crucial role of government in affecting the costs of exchange in history.