Jei

JOURNAL OF ECONOMIC ISSUES

Vol. XXXVIII No. 4 December 2004

An Evaluation of the Role of the State and Property Rights

in Douglass Norths Analysis

Ronaldo Fiani

This paper intends to show that the role Douglass North has attributed in his latest works
to the modern State in the working of economic system permits the development of a
political economy theory which joins the political and economic dimensions with
abstract generalizations quite different from and more interesting than the ahistorical
and asocial neoclassical ones, at the same time avoiding a narrow descriptive character.
Notwithstanding the fact that some of these ideas have been presented elsewhere,1 more
development is necessary, especially concerning the possibility of spontaneous coopera-
tive behavior to dismiss the role of the State in property rights assignment and enforce-
ment as a necessary condition for modern market functioning. Thus, the next section
explores in Norths analysis the links between transaction costs, multidimensional prop-
erty rights, and third-party enforcement in modern societies, which demands the States
intervention not only in the enforcement but also in the definition of property rights, as
a necessary condition for market operation.
The third section discusses the modern institutional analysis of spontaneous emer-
gence of social cooperation essentially founded on Robert Axelrods contribution, for
its approach seems to contradict the role of the State as a third-party agent to define and
enforce property rights. The fourth section discusses the determinants of the States
institutional action to define and enforce property rights according to Norths analysis.
Then, it will be demonstrated that Norths analysis of these determinants is unsatisfac-
tory but states a future research agenda for the study of the relationship between politi-
cal and economic systems. The last section summarizes the most important questions
for future research.

The author is Associate Professor in the Economics Institute, Federal University of Rio de Janeiro. He is indebted to Geoffrey
Hodgson, Glen Atkinson, and two anonymous referees for valuable comments on an earlier version of this paper.

1003

2004, Journal of Economic Issues

1004 Ronaldo Fiani

Development and Institutions in Douglass Norths Analysis

The evolution of Norths ideas is quite complex, and it is not our fundamental mat-
ter of concern here. We are interested in comparing Norths approach in his latest work
(during the 1990s) to the present trend of studying only the spontaneous emergence of
norms through very abstract models in more orthodox approaches to institutions. How-
ever, some very brief remarks on the evolution of Norths ideas are necessary, at least to
let the unaware reader know about some quite dramatic changes in Norths point of
view in the course of his work.
Norths first work (The Economic Growth of the United States from 1790 to 1860) was
fundamentally concerned with an empirical analysis of the functioning of markets in a
process of economic growth. This work would build the link between North and what
have been called the cliometric school (also known as the new economic history),
which was characterized by applying quantitative methods and (neoclassical) economic
theory to historical analysis.
This initial link with neoclassical theory would prove very difficult to break in
Norths subsequent works. The most important difficulty with early Norths neoclassi-
cal analysis would be to explain the permanence of inefficient institutions, that is, insti-
tutions that do not favor economic growth.2 The problem of the definition of property
rights, its assignments, and enforcement was directly related to the nature (efficient or
inefficient) of institutions and has a central role in Norths analysis.
The problem of the permanence of inefficient institutions would produce perhaps
the most important changes in Norths thought. In his early work on this issue (North
and Thomas 1973), the definition, assignment, and enforcement of property rights
always changed in an efficient way, in response to the variations in relative prices of land
and labor. These variations were caused by the European demographic cycles during the
Middle Ages, in a Malthusian-like cycle. Thus, a reduced population increased the rela-
tive price of labor in comparison to land and this, in turn, produced simultaneously a
decrease in feudal obligations related to direct labor extraction and an increase in mar-
ket-oriented usages of land, such as land tenancy. This movement produced population
increase and the consequent expansion of agricultural frontier and the growth of com-
merce, which was caused by the diversity of agricultural products. However, as the stock
of potential agricultural land was exhausted, diminishing returns started to operate pro-
ducing inflation and increasing the price of land relative to labor: the whole cycle was
reverted with landlords reducing the number of tenants on their lands and increasing
the extraction of direct labor by the means of the imposition of feudal obligations.
In this early analysis of the process of economic growth and institutional change,
the economic growth causes institutional change mechanically through individuals fac-
ing relative scarcity of labor and land. This is quite amazing when one considers that in
the same book, North and Robert Thomas discussed the differences between the suc-
cessful development in England and the Netherlands and the economic failure of Spain
and France from the sixteenth to the seventeenth centuries (1973). While in the same
 Role of the State and Property Rights in Douglass Norths Analysis 1005

period, first in the Netherlands and then in England, institutions were created to safe-
guard and enforce property rights, particularly in capital markets; in France and Spain,
absolutist kingdoms made property rights insecure. The result was that while the Neth-
erlands and England succeeded in overcoming the Malthusian check, France and Spain
continued to be submitted to population growth cycles.
After reading the book, the inevitable conclusion is that it poses at least two
problems:

1. Why did France and Spain not imitate the pattern of property rights protection
of the Netherlands and England?
2. If the answer to problem 1 involves the State and its political structure, what
were the differences?

These two problems are quite difficult to handle without a theoretical model, and it
is worse when the analytic frame preserves a clear neoclassical nature. The historical evi-
dence points to the survival of property rights which do not favor economic growth for
long periods. That could not be reconciled with the notion that property rights change
spontaneously, in an efficient way, when factors relative prices change. In his 1981
book, Structure and Change in Economic History, North tried to respond to both problems.
North asserted then that [t]he reason for the differential growth rates among the merg-
ing nation-states of Europe during the seventeenth century is to be found in the nature
of property rights that had developed in each. The type of property rights established
was the outgrowth of the particular way each nation-state developed (148).
The importance of Norths change of approach must not be minimized here. He
states that:

(a) The concept of property rights is essential to understanding economic growth.

(b) The development of property rights is specific to each nation, and it is not
subject to a general, ahistorical law of change as it was before, when North
considered development a spontaneous response to relative prices change.

Before we develop the discussion of (a) and (b), it is important to properly under-
stand the role of property rights in Norths new approach. In effect, as we are going to
realize, the concept of property rights is central to Norths analysis of institutions
through the impact of the costs of transacting in long-term growth. The first step is to
carefully consider Norths definition of transaction costs: It is the cost of measuring the
valuable attributes of the goods and services or the performance of agents in exchange
that is the fundamental key to the cost of transacting (1992, 7). This definition of trans-
action costs inherently relates these costs to the measurement and enforcement of prop-
erty rights,3 a kind of association not unanimously shared by authors of what became
known as the new institutional economics. For example, Ronald H. Coase in his first
1006 Ronaldo Fiani

article (1937), which coined the term transaction costs, characterized transaction
costs loosely as comprising all the costs incurred when a transaction is performed
through the market, with no direct reference to what is really being transacted. More
radically, Oliver E. Williamson (1990) explicitly denied any relevance to the concept of
property rights in studying transaction costs: Albeit illuminating, the property rights
approach to economic organization pulls up short. Akin to the economic theory of
socialism, which held that the central exercise was to get the prices right . . . the eco-
nomics of property rights maintains that the basic need is to get the property rights
straightafter which markets will reliably assign resources to high valued uses.
Arguments of both kinds truncate the study of economic organization unnecessarily
(109).
Williamsons critique of the concept of property rights is unfair. While it is true
that some authors have discussed property rights in a simplistic way, it is also true that
others such as Armen Alchian, Yoram Barzel, and North himself have not. The latter
understood that, as property rights always comprise multiple dimensions which are
costly to measure, some of them remain unmeasured and so there is no such thing as
perfectly assigned property rights. Property rights assignment and enforcement are and
will always be problematic. For that reason institutions are so important: political and
economic institutions assign and enforce property rights. This is the first analytical
advantage of studying transaction costs by means of the concept of property rights.
It must be clear that North acknowledges goods and services multiple attributes,
taking into account the difficulty of measuring them and the agents performance as the
source of transaction costs. Traditional economical analysis treats goods, services, and
performances as essentially one-dimension objectsto be reduced to their quantity
while solving equations to get their priceswhat excludes most of the problems eco-
nomic institutions are concerned with. To recognize that goods, services, and perfor-
mances have multiple dimensions makes a quite different picture emerge.
Yoram Barzel offered strong evidence about the importance of considering multi-
ple dimensions in economic analysis (1997). He discussed the interesting case that
occurred in the United States in August 1971. Contrary to what the conventional the-
ory would predict, gasoline price control did not result in offer shortage. Instead of
reducing quantity, as traditional theory would have predicted, gasoline sellers changed
gasoline attributes. In effect, it is not gasoline that gas stations sell. Instead, what a
consumer buys in gas stations is a variable bundle of rights associated with the physical
good gasoline: the right to buy it twenty-four hours a day, the right to use credit card
instead of cash, the right to have convenience services, and so forth. As a result of the
price control imposed in August 1971, gas stations kept the quantities sold but reduced
the attributes of the bundle of rights associated to it. Gas stations started to open only
twelve hours a day, to reject credit card payments, to reduce convenience services and so
on, resulting in no offer shortage, to the disappointment of economic previsions
(2130).
 Role of the State and Property Rights in Douglass Norths Analysis 1007

In other words, this evidence shows that once something is transacted what is really
sold is a bundle of rights related to the goods or services multiple dimensions. Since
some of these dimensions are not completely specified, some of those rights are poorly
defined, not clearly attributed (to use Barzels words, it is in the public domain) and,
consequently, imperfectly enforced, which may cause agents to spend resources in order
to capture these rights. The less specified and enforced those rights are, the fewer
resources will be spent.
That brings the cost problem of identifying and measuring all the relevant attrib-
utes of goods and services to the parties involved in the transaction to the forefront of
the discussion, since these two steps are previous to the definition, assignment, and
enforcement of the rights associated with those attributes. The cost problem belongs to
the core of transacting and, more specifically, to the core of making a contract. If the
expected cost of identifying and measuring all the relevant attributes of goods and ser-
vices to the parties involved in the transaction is substantial, property rights will be
poorly defined, assigned, and enforced. As a result transaction costs will increase and
the expected gains of trade will reduce proportionally.
There is a second analytical advantage of Norths approach to transaction costs
through property rights: this kind of approach analyzes transactions as essentially a
transference of property by parties who are allowed to do so, and so does not consider
transactions as mere transfers of physical goods. Using John R. Commons terminology,
Norths institutional analysis is concerned with transactions (transfer of property) and
not with exchange (delivery of physical goods) (see Commons [1934] 1990, 5560).
Although North does not distinguish between transactions and exchange as Commons
did, North is clearly talking about property transfer. Thus, he is not subject to Com-
mons criticism of orthodox theory, which mixes the property dimension with the physi-
cal dimension of trade as if they were the same thing.
Therefore, trade gains are directly associated with the definition, assignment, and
enforcement of the multiple attributes which constitute a bundle of property rights. The
more those attributes are well defined, assigned, and enforced, the more institutions
will work as incentive systems to nations economic development. According to North,
the simplest and cheapest way of achieving that is through close repetitive personal rela-
tionships, as game theory has demonstrated: By personal exchange, I refer to a world in
which we deal with each other over and over again in small-scale economic, political and
social activity, where everybody knows everybody, and where under those conditions, to
use a simple illustration from game theory, it pays to co-operate. That is, game theory
says that human beings co-operate with each other when they play a game over and over
again, when there is no end game, when they know the other parties to exchange, and
when there are small numbers (North 1999, 21).
However, North advises us not to expect this kind of social relationship, which
emerged since the development of German chemical industry in the second half of the
nineteenth century, to be the standard relationship in modern society: The world that
it has produced is characterized by impersonal exchange. It is a world in which our
1008 Ronaldo Fiani

dependence rests upon people all over the world, whom we do not know; there are no
repeated dealings; and large numbers of players are involved. Therefore it is a world in
which the game is played differently. In game theory, we say such a world is one in which
it pays to defect (1992, 21).
Norths distinction between economic transactions based on personal relationship
versus impersonal relationship is even more important to properly understand the insti-
tutional economic role North concedes to the modern State. In a previous work, North
had already pointed to the importance of that distinction and its consequences: The
measured transaction cost of a society where there is a dense social network of interac-
tion is very low. . . . Under such conditions, norms of behavior are seldom written
down. Formal contracting does not exist, and there are few formal specific rules. How-
ever, while measured transaction costs are low . . . production costs are high, because
specialization and division of labour are limited to the extent of markets that can be
defined by personal exchange (1989, 1320).
For North, the economic system representation, as something ruled by a spontane-
ous order operating through social norms and culturally consolidated conventions of
which individuals are persistently ignorant, seems to fit to a society where the division of
labor has not progressed enough, thus making costs of transaction low but costs of pro-
duction high. This is not the kind of description suitable for modern economic
societies:
At the other extreme from personal exchange is a world of specialized interde-
pendence in which the well-being of individuals depends upon a complex struc-
ture characterized by individual specialization and hence by exchange ties that
extend both in time and space. A pure model of this world of impersonal
exchange is one in which goods and services or the performance of agents is
characterized by many valued attributes, in which exchange takes place over
time, and in which there are not repeated dealings. Under these forms of
exchange, the costs of transacting can be high, because there are problems both
in measuring the attributes of what is being exchanged and problems of enforc-
ing the terms of exchange; in consequence there are gains to be realized by
engaging in cheating, shirking, opportunism etc. . . . As a result, in modern
Western societies we have devised formal contracts, bonding of participants,
guarantees, brand names, elaborate monitoring systems, and effective enforce-
ment mechanisms. In short, we have well-specified and well-enforced property
rights. (1989, 1320)
In spite of being lengthy, the quotation above is very important to properly settle
the limits of economic spontaneous order and its secondary importance to modern
developed economic societies. The developed labor division in our time demands a par-
ticular institutional frame, which considers the importance of the progressive complex-
ity of economic interactions. This progressive complexity is more institutionally
demanding as we recognize that what is transacted is a bundle of property rights with
 Role of the State and Property Rights in Douglass Norths Analysis 1009

multiple dimensions, costly to measure but essential to define the gains of trade. The
institutional frame prerequisites to cope with this complex situation is analyzed by
North:
The institutional requirements that are necessary in order to be able to realize
the productivity gains associated with the model of impersonal exchange out-
lined above entail both the development of efficient products and factor mar-
kets and of a medium of exchange with reliable features. The establishment of
such a set of property rights will then allow individuals in highly complex inter-
dependent situations to be able to have confidence in their dealings with indi-
viduals of whom they have no personal knowledge and with whom they have no
reciprocal and ongoing exchange relationships. This is only possible as the
result, first, of the development of a third party to exchanges, namely government,
which specifies property rights and enforces contracts; and second of the exis-
tence of norms of behavior to constraint the parties in interaction. (1989, 1320,
emphasis added)
From the passage above it is clear that, in Norths analysis, the complex social envi-
ronment characteristic of modern societies makes necessary the presence of the State,
not only to enforce property rights but also, and specially, to specify those rights. It begs
the question of what the role of social norms and conventions in property rights specifi-
cation and enforcement is. Since Institutions, Institutional Change, and Economic Perfor-
mance (1990) North has endeavored to properly set the meaning of social norms and
conventions spontaneously developed relating to property rights. In another work,
North made it clear that [h]owever they are formed, and however they evolve, norms
play a critical role in constraining the choice set at a moment of time as well as in the evo-
lution of institutions through time. They are important at a moment of time precisely
because of the costliness of measurement and the imperfect enforcement of rules
(1993, 14).
It means that ideas and values embodied in social norms and conventions matter;
moreover, North observed that [t]hey do so because of slack in the system, agency
costs, consumption at the job, and so forth, all of which result from the costliness of
measurement and enforcement (1993, 15). It means that norms are important not in
absolute terms but in relation to the costs of formally designed institutions. Social
norms that claim cooperative behavior are significant for economic growth and develop-
ment as they reduce the costs associated with designing formal restraints to prevent
anti-cooperative actions from individuals. But in modern societies based on impersonal
transactions, one should not expect that norms and values alone would solve the prob-
lem of assigning, measuring, and enforcing property rights.
So, the existence of norms of behavior constraining individuals is only secondary to
the confidence necessary to economic relations. It is important to clarify that for North
there is no equivalence between the States action and spontaneous social norms (and
conventions). The role of the State is more significant. The relatively growing impor-
1010 Ronaldo Fiani

tance of the State specification and enforcement in modern societies property rights
gives the answer to the permanence of ineffective rights: The answer is quite clear: The
breakdown of personal exchange is not just the breakdown of a dense communication
network, but it is the breakdown of communities of common ideologies and a common
set of rules in which all believe. The rise of impersonal rules and contracts means the rise
of the state and with it unequal distribution of coercive power. This provides the oppor-
tunity for individuals with superior coercive power to enforce the rules to their
advantage, regardless of their effects on efficiency (1989, 1321).
This process brings the States action in property rights to the forefront and makes
it possible for individuals and groups to use the States coercive power in their favor, and
the ensuing political bargaining has no connection with economic efficiency. To illus-
trate this point North gave several historical examples of inefficiently defined property
rights that lasted for long periods of time. One of those examples is the case of Spanish
Mesta, a shepherds guild with the privilege of free passage of its sheep through any land
property in the country. North argued that privilege had hindered agriculture develop-
ment in Spain for centuries (1981, 150151).
But the really important point here is that North perceives the progressive formal
nature of those institutions, defining and enforcing property rights as a direct conse-
quence of the increasing division of labor. That result moves the State to the center of
the institutional analysis of modern societies. But before discussing the role of the State,
it is necessary to consider first the very popular analysis of spontaneous emergence of
social cooperation, for it seems to deny the role of the State in defining and enforcing
rights. This is our next subject.

Spontaneous Social Cooperation and Third-Party Enforcement

The importance of third-party enforcement to achieve social cooperation is not

consensual among modern theorists who study the role of institutions. More precisely,
the importance North concedes to the State in the working of markets is far from being
an established truth in modern institutional analysis. In this section, effort will be made
to summarize in a few words the alternative approach to market and society functioning
that rejects third-party enforcement as necessary to economic and social interactions.
Axelrods analysis of spontaneous cooperation, which has become the reference for
social cooperation analysis, will be discussed. It does not mean that Axelrods analysis is
the only one of this kind, or the only significant one. There is an enormous quantity of
papers working on the same kind of approach; the interested reader may refer to
Bicchieri 1993, Schelling 1960, Schotter 1986, Sugden 1989, and Young 1998, just to
name a few. The reason I decided to concentrate on Axelrods work is his option for an
evolutionary method. This option has attracted a legion of admirers of his work, even
critical analysts like Sean P. Hargreaves Heap and Yannis Varoufakis (1995). Axelrods
 Role of the State and Property Rights in Douglass Norths Analysis 1011

analysis of the evolutionary development of norms of cooperation is perhaps the most

popular of its kind today.
The plausibility that economic interactions regulation might be provided exclu-
sively by spontaneous mechanisms has been sustained in the economic literature chiefly
through formal abstract demonstration (generally derived from game theory concepts)
of the spontaneous emergence of cooperation. If cooperation emerges spontaneously
then it is straightforward that property rights will be devised (somehow) without State
intervention to assure cooperation in the economic sphere of social relations. The con-
sequence is that the analysis of property rights becomes of less importance itself for the
efficient property rights structure will be generated more or less automatically. It is
important to observe that this kind of answer solves the problem of property rights
determination indirectly through the analysis of the evolution of rules of conduct. If
social cooperative rules of conduct necessarily evolve, it is possible to expect cooperation
in definition and enforcement of the property rights necessary to make the economic
system work.
Axelrod presented the famous computer tournament of sixty-three strategies pro-
posed by specialists in a repeated game (1984).4 Axelrod then argued that the superior
performance of tit-for-tat5 in the tournament is a clear demonstration that tit-for-tat is
the best strategy and not only for a given environment but also if one admits that the
environment evolves in a particular way, when populations of strategies with best perfor-
mance are allowed to grow their populations according to their accumulated payoffs. To
distinguish this particular model of evolution from the generally accepted one, which
admits mutation and combination of genes, Axelrod considered that his approach was
an ecological and not an evolutionary one (51).
Axelrod (1984) was emphatic about the importance of tit-for-tat being nice, nice-
ness meaning that a strategy is never being the first to defect, what in his opinion was a
strong evidence of the optimality of being cooperative. Cooperative behavior has a
rather specific meaning for Axelrod: you must never be the first one to defect, but you
must be always ready to retaliate against a defection. For Axelrod, cooperation admits
retaliation, but again you must be always ready to forgive any defection if the other
player cooperates again. If you are not ready to retaliate against a defection, you may be
vulnerable to exploitative strategies. However, if you are not ready to forgive, you may be
trapped in a succession of endless retaliations that would lower both your and the
opponents payoffs.
These conclusions about spontaneous emergence of cooperative behavior were
reinforced under more sophisticated hypothesis in Axelrod 1997. As it was mentioned
before, Axelrod (1984) did not develop a true evolutionary model and this most recent
work was devised to elaborate a true evolutionary analysis, among other relevant exten-
sions of his previous results. The elaboration of a true evolutionary analysis demands
some mechanisms of combination and mutation of strategies. That was accomplished
through genetic algorithms (1997, 1720). Axelrod described the results so obtained:
The results were quite remarkable: from a strict random start, the genetic algorithm
1012 Ronaldo Fiani

evolved populations whose median member was just as successful as the best rule in the
tournament, tit for tat. Most of the strategies that evolved in the simulation actually
resemble tit for tat, having many of the properties that make tit for tat so successful
(1997, 20).
The conclusion seems clear: for Axelrod tit-for-tat was not only the best strategy in
simplified environments but also a benchmark for performance evaluation even in a
complex world with mutations and crossover. The more a rule of behavior resembles
tit-for-tat, the more successful it will be in an evolutionary selection process. Thus, for
Axelrod, the viability of spontaneous social cooperation emergence through evolution-
ary mechanisms was demonstrated, even in the unfavorable environment of prisoners
dilemma.
Axelrods conclusions became a milestone in institutional analysis and tit-for-tat a
reference for the study of spontaneous cooperation emergence beyond the strict realm
of computer tournaments, as Christina Bicchieri clearly asserted: The very characteris-
tics that make tit for tat successful in computer tournaments are also likely to play an
important role in all those prisoners dilemmalike circumstances in which there is
repeated interaction but the players are uncertain as to the opponents character. Espe-
cially when the number of repetitions is small, and experimenting more costly, tit for tat
seems likely to be chosen by a player who wants unambiguously to signal his intentions
and benefit from the possibility of joint cooperation (1993, 2456).
If Axelrods simulations were decisive in demonstrating that the emergence of
spontaneous social cooperation is a strong possibility, Norths dichotomy between small
and less developed societies with no third-party enforcement of property rights and
modern societies with a necessary third-party enforcement of rights (through States
action) would become a serious mistake, but this does not seem to be the case. Actually,
game theorists have strongly criticized Axelrods simulations. Kenneth Binmore (1994,
1998) surveyed the worries about Axelrods results. The most important are:

1. In Axelrod 1984 the selection process could have converged to any of the large
number of Nash equilibria of the game resulting from the sixty-three strategies
proposed, provided that the initial strategy distribution was selected suitably.
2. Actually, the good performance of tit-for-tat is significantly dependent on the
initial population of strategies, for with a different starting set of strategies (and
a random initial distribution of strategies) tit-for-tat becomes completely
overcome by other strategies, which do not necessarily show nice properties.
3. Contrary to Axelrods (1984) reasoning, it is perfectly possible that mean
strategies overcome strategies with nice properties as tit-for-tat. For example, if a
population of dove strategies (meaning always cooperate) is invaded by a
population of tat-for-tit (the same of tit-for-tat except for that tat-for-tit begins
defecting and tries to exploit its opponent), the final population may consist
only of tat-for-tits, which cannot be invaded and is not a nice strategy.
 Role of the State and Property Rights in Douglass Norths Analysis 1013

4. Finally, even in the case of all individuals being tit-for-tats, tit-for-tat is not
evolutionary stable; it is vulnerable to invasion by simplifying mutations of itself
as dove strategy. Whereas tat-for-tit cannot be invaded by similar simplifying
mutations, neither dove strategy nor hawk strategy (meaning always defect) may
invade tat-for-tit.

Considering the above criticism, Axelrods results seem far from demonstrating the
spontaneous emergence of social cooperation. There are neat reasons to doubt the idea
that evolution will select a specific pure equilibrium in an infinitely repeated game be it
tit-for-tat or other specific strategy. Considering the question about which equilibria will
be eventually selected by evolutionary forces, Binmore concluded that:
One cannot say anything definitive about precisely which of these evolution
will select, because this will depend on accidents of history about which little
information is likely to be available. However, the evidence from simulations
does strongly suggest that it is unlikely that a pure equilibrium will get selected.
One must anticipate the selection of a mixed Nash equilibrium. When such
equilibrium is realized, many different rules of behaviour for the indefinitely
repeated Prisoners Dilemma will survive together in a symbiotic relationship.
However, as all married folk know, to be part of a symbiotic relationship does
not imply that pure harmony reigns. (1994, 203)
If it is not demonstrated that a nice rule of conduct will necessarily emerge and
dominate through the operation of evolutionary forces, what is the correct approach to
the role of norms and conventions in institutional analysis? Geoffrey Hodgson
answered the question:
[M]any important legal rules, enforcements and structures cannot emerge spon-
taneously through individual interactions. They require additional third party
enforcement by the state or another strong institution. This means that many
key institutions and legal relations, arguably including property and markets,
exist as a result of a combination of spontaneous and statutory mechanisms.
The existence of one institution has to be considered in relation to the others
that help to support and sustain it. Institutions are generally and inevitably inter-
twined, and provide essential mutual support for one another. (2002, 13, emphasis
added)
The acknowledgement of the interconnection of formal and informal institutions,
the last ones spontaneously generated as social norms and conventions, was expressively
stated by North when he discussed the pervasiveness of informal constraints and the
fact that similar constitutions imposed on different societies result in very distinct out-
comes (1990, 36). It is a much richer approach to institutional analysis to admit the
interface between formal and informal institutions than to try to demonstrate that the
only kind of institution relevant to social analysis is the spontaneously generated one.
1014 Ronaldo Fiani

Even recognizing the relevance of social norms and conventions, they must be stud-
ied in their interaction with legal rules established by the state. As Hodgson stated:
Individual property is not mere possession; it involves socially acknowledged and
enforced rights. . . . It is not simply a relation between an individual and an object. It
requires some kind of customary and legal apparatus of recognition, adjudication and
enforcement. Such legal systems made their first substantial appearance within the state
apparatuses of ancient civilisation. Since then the state has played a major role in the
establishment, enforcement and adjudication of property rights (2002, 6).
We have until this point only discussed the relevance of the State for property rights
definition and enforcement. Now will be discussed the determinants of the States
action in establishing, adjudicating, and enforcing property rights according to North.

States Institutional Action according to North

The historical example of Mesta shows the relevance of the States intervention in
the definition and assignment of property rights. For North, the State is responsible for
economic performance through property rights specification: A theory of the state is
essential because it is the state that specifies the property rights structure. Ultimately it is
the state that is responsible for the efficiency of the property rights structure, which
causes growth or stagnation or economic decline (1981, 17).
In its earlier formulation, Norths concept of the State was not conceived as a politi-
cal arena, where different interests meet and confront themselves, but as an agent with
its own objectives, at least between certain limits: In fact, the property rights which
emerge are a result of an on-going tension between the desires of the rulers of the state,
on the one hand, and the efforts of the parties to exchange to reduce transaction costs,
on the other. This simple dichotomy actually is anything but simple, since the parties to
an exchange will devote resources to influencing the political decision makers to alter
the rules. But at least as an initial starting point for theorizing, it is useful to separate a
theory of the state from a transaction cost approach to property rights (1981, 18).
To perform that function (to sell justice and protection), the State monopolizes the
definition and enforcement of property rights (North and Thomas 1973, 97). The pay-
ments for those services are the States taxes. That exchange is advantageous in the sense
that the State shows economies of scale in those services and it would consequently be
more expensive for private agents to provide justice and protection for themselves. As
long as those economies are not exhausted, the enlargement of the States definition
and enforcement of property rights increases societys revenues and produces savings to
be divided between the State and society. Obviously there will be a distributional con-
flict concerning this division: both state and society will try to enlarge their own share at
the expense of the other. In a preliminary analysis of this distributional conflict, North
and Thomas observed that [t]he more monopoly power an existing prince could
 Role of the State and Property Rights in Douglass Norths Analysis 1015

claimthat is, the less close or threatening were his rivalsthe greater the percentage of
rents which the state could appropriate (1973, 98).
That first approach will be developed more deeply in what North called his neoclas-
sical State model (1981). Its starting point is the hypothesis of State rulers who maximize
their utility. North specified the behavior of rulers who will act as discriminator monop-
olists making distinctions among the interest groups, while defining and attributing
property rights in order to maximize his revenue. Nevertheless, any ruler will have limits
to his discriminating behavior because there will always be rivals to offer the same kind
of services (23). About the rulers discriminating behavior North stated that:
The basic services that the state provides are the underlying rules of the game.
Whether evolving as a body of unwritten customs (as in the feudal manor) or as
a written constitution, they have two objectives: one, to specify the fundamental
rules of competition and cooperation which will provide a structure of property
rights (that is, specify the ownership structure in both factor and product mar-
kets) for maximizing the rents accruing to the ruler; two, within the framework
of the second objective, to reduce transaction costs in order to foster maximum
output of the society and, therefore, increase tax revenues accruing to the state.
(1981, 24)
North observed that (1) those objectives are not obligatorily consistent because the
set of property rights rules which maximizes the rulers revenue is not necessarily the
same as that which maximizes social product (1981, 2425) and (2) there are agency
problems between the ruler and his bureaucracy and therefore some rent dissipation
will always happen in consequence of a collusion among bureaucrats and constituents
(27). The services offered by the ruler have different cost curves; therefore some of them
are essentially public goods while others show the conventional U-shaped average cost
curve (25). About the States institutional action, North concluded that [t]he ruler will
specify a set of property rights designed to maximize his monopoly rents for each separa-
ble part of the economy by monitoring and metering the inputs and outputs of each.
The costs of measuring the dimensions of the inputs and outputs will dictate the various
property rights structure for the diverse sectors of the economy, which therefore will be
dependent on the state of the technology of measurement (26).
It is important to understand that North defined the States objective of maximiz-
ing revenue taxes as the factor that explains the relationship between the definition of
property rights and measurement technology while recognizing that there are limits to
that kind of action: The ruler always has rivals: competing states or potential rulers
within his own state. The latter are analogous to the potential rivals to a monopolist.
Where there are no close substitutes, the existing ruler characteristically is a despot, a
dictator, or an absolute monarch. The closer the substitutes, the fewer degrees of free-
dom the ruler possesses, and the greater the percentage of incremental income that will
be retained by the constituents (1981, 27).
1016 Ronaldo Fiani

The competition between the ruler and potential substitutes is motivated not only
by tax revenue distribution; definitions of property rights and services offered are also a
matter of concern to interest groups. They are influenced by interest groups bargaining
capacity: Constituents may, at some cost, go over to a competing ruler (that is, another
existing political-economic unit) or support a competitor for ruler within the existing
state (North 1981, 27). Unfortunately, North did not satisfactorily develop the line of
reasoning to the modern State case. At the same time North presented his neoclassical
theory of the State, he admitted its weakness when considering modern democracies:
The model of the state is deficient in other ways too, but it is particularly deficient
when we move from a single ruler to the modern pluralist state. A theory of the resolu-
tion of the conflicts in such a state has baffled modern political scientists (68).
In his last book, Institutions, Institutional Change, and Economic Performance (1990),
North showed a clear effort to enrich his State analysis from the somewhat simplistic
scheme of a maximizing ruler. He remarked that [t]he existing structure of rights (and
the character of their enforcement) defines the existing wealth-maximizing opportuni-
ties of the players, which can be realized by forming either economic or political
exchanges. Exchange involves bargains made within the existing set of institutions, but
equally the players at times find it worthwhile to devote resources to altering the more
basic structure of the polity to reassign rights (47).
The preceding statement shows that individuals strategically consider the possibil-
ity of investing in political changes in order to redefine property rights and, therefore,
existing gains opportunities. It is, of course, completely different from the neoclassical
model of State in which a maximizer ruler negotiates property rights definition and pub-
lic services in exchange for tax revenues. North (1990) presented a new State concept
with a multiplicity of agents that may invest in changes in the polity structure, which
defines and enforces property rights. He recognized the neoclassical model of State as a
first approach and a simplified model (48), and he explicitly admitted the historical
limitations of the neoclassical model of State: When we move from the historical char-
acter of representation in early modern Europe to modern representative democracy,
our story is complicated by the development of multiple interest groups and by a much
more complicated structure devised to facilitate (again given relative bargaining
strength) the exchange between interest groups (49).
So, the representation of the modern State as a tax revenue maximizer ruler acting
like a standard economics textbook discriminating monopolist is rejected by North.
This is not a convenient model when one studies modern democracies, characterized by
multiple interest groups and very complex institutional structure. That institutional
complexity and interest groups multiplicity work against the idea of a single maximizer
ruler: Because there are multiple interest groups, no particular interest group that a leg-
islator may represent can form a majority. Therefore, legislators cannot succeed acting
alone, but make agreements with other legislators, with different interests (1990, 50).
 Role of the State and Property Rights in Douglass Norths Analysis 1017

The presence of multiple interest groups and legislators puts up the question of
how those legislators might behave. Thats a rather difficult question for North as it
involves the analysis of free rider behavior and values such as justice and equity. About
them North observed that [t]hese issues appear to show in the voting behavior of legis-
lators; it is widely observed that one cannot explain the voting behavior of legislators
within the narrow confines of a principal/agent model, in which the agent (the legisla-
tor) is faithfully pursuing the interests of the principal (constituents). The agents own
utility functionhis or her own sense of the way the world ought to beappears to play a
role in the outcomes (1990, 21).
But legislators who assign property rights are not the only agents to constitute the
State. These rights have to be enforced, and this is the function of the judiciary for
[r]ules are enforced by agents (police, foremen, judges, juries, and so on) (North 1993,
14). He admitted the same kind of difficulty, identified before with regard to legislators,
influencing judges decisions: judges with lifetime tenure can and do vote their own
convictions, as even the most casual study of courts in general and the Supreme Court
in particular testifies (1993, 18).
It must be understood that Norths rejection of his neoclassical model of State does
not mean a rejection of the idea that legislators and judges in a democracy have some
degree of autonomy when taking their decisions. North considers the representation
implicit in agent-principal political analysis of modern State as a political arena, where
the legislator or judge is simply an agent of interest groups (his principals), as incomplete
and so incorrect. The legislator/judge has his own normative view of the world and will
try to implement it whenever it looks possible and desirable to him. And the possibilities
of acting autonomously are not rare, since modern democracy increases the number of
political exchanges and what became known as rational ignorance from the voter6
(1990, 51).
It brings us to the last question: the autonomy of legislators and judges and their
relationship with each other and with the interest groups supporting them. Rather
deceptively, Norths ideas about this question are quite superficial. He has limited him-
self to agreeing with William H. Riker (1976) when the latter showed skepticism about
the possibility of constitutional forms preventing arbitrary use of power (North 1990,
60). But this is not an answer to the question of why legislators (and to some degree
judges) have arbitrary power in some circumstances, whereas in other ones they must act
exactly according to the groups supporting them. It is inevitable to agree with Itai Sened
(1997, 47) when he stated, North advanced the transaction costs theory to recognize
the importance of political structures but, so far, has fallen short of complementing it
with a theory of the state.
1018 Ronaldo Fiani

Conclusions: Elements for Future Research

The recognition of the role of the modern State in property rights specification
demands a theoretic analysis of its political activities regarding those rights. North
began with his neoclassical model of State which he would later reject, considering it
too simplistic to understand modern democracies, which present complex networks of
political institutions connecting legislators in a process of political bargain among them-
selves and interest groups. Jack Knight (1992) criticized Norths approach, which con-
siders institutions as being determined by the effort to reduce uncertainty in human
interactions. Economic and political institutions would be the result of political bargain
among groups with distributive purposes.
Knights criticism brings to the forefront the political process through which eco-
nomic institutions are created. The acknowledgement of political processes and struc-
tures relevance to institutional analysis brings back questions that political scientists
have been working on for a long time. Their work gives a picture of the State more com-
plex than Norths neoclassical model of the State. Particularly interesting is the work by
Joel S. Migdal (1987, 1988), when he discussed why some States seem strong enough to
implement their rules while others are so weak that they have to accommodate almost
all of its pressure groups and regional leaders. His research points to two different
factors.
The first factor is the incessant competition between the State and other political
organizations to establish their political dominance and the resources the State may
employ in this competition. Contrary to Norths early view, the State is not necessarily
the single national ruler; it has to fight for political power against other political organi-
zations or regional strong leaders, remarkably in the Third World. The second factor is
that States are inserted differently but necessarily in the economic and political interna-
tional arena. It results in relations of trade, borrowing, factor movements, and so on,
that affect not only the social structure in each country but also the constraints the State
faces and the resources it has to act politically.
Political bargain is not usually motivated by economic efficiency and, therefore, the
kind of property rights assignment that will result from it is a matter of economic con-
cern. It poses two questions for a future agenda of research when one admits the role of
institutions in economic development and growth. First, it is not clear when legislators
have to serve interest group demands and when they are free to follow their own values
and objectives. Second, when legislators have significant degrees of freedom to follow
their own ideals, what are those ideals and how they come into play? Thirdly, when legis-
lators and politicians have to serve interest groups, what determines which groups will
be served?
The first question relates to legislators legitimacy, a concept largely discussed in
political theory but not appropriately considered by economists, even economists who
recognize the importance of institutions and political structures to explain economic
performance in the long run. Why, in the same societies, are there moments when poli-
 Role of the State and Property Rights in Douglass Norths Analysis 1019

ticians and legislators may do almost whatever they want no matter how unpopular it is,
while there are moments when they have to concede everything to almost each consti-
tuted interest group? The notions that (1) the State frequently has to compete with other
organizations to set up its intended monopoly of violence and (2) States are differently
but necessarily inserted in the international political arena, as discussed in Joel S.
Migdals works, may help to start to answer this first question.
Even if we had a satisfactory answer to the first question, then there comes the sec-
ond one: what explains politicians and legislators ideology at the moment they are free
to do what they want? Of course, this question entails sociological analysis to under-
stand the social origins of political ruler classes and so to comprehend its values and
morals, but unfortunately this is another topic not considered by economists, even
when they do their institutional studies. Finally, since the work of Mancur Olson (1965)
on interest groups, economists have given some attention to the last question, but there
is a lot to be done to integrate this analysis with the two previous questions.
Unfortunately, Douglass North did not pursue those questions. But he has the
great merit of establishing the foundations for an analysis that effectively integrates the
economic with the political problems of economic growth and development, by identi-
fying the role that the modern State has in property rights specification. This is an
important open way to research which should not be lost with barren investment in
models of spontaneous cooperation that are inadequate for modern and complex
societies.

Notes

1. See Fiani 2003.

2. Douglass North distinguished an institution as efficient as long as it promotes economic
growth, for it is incorrect to discuss efficient institutions in the Paretian sense. As is
well-known, the Pareto optimum takes the wealth distribution as given and then asks what
would be the resource allocation that would maximize the social welfare, given the demand
pattern generated by that wealth distribution. But the result of institutional change is always
wealth redistribution, and so two different sets of institutions will produce two different and
incomparable Pareto-efficient solutions.
3. This is not the only instance where North clearly related transaction costs to property rights;
this connection is present throughout his work. For example, see also North 1981 (18) and
1990 (33).
4. As the game had a finite number of plays, some game theorists did not accept Robert
Axelrods tournament as a representation of a game infinitely played. But as none of the strat-
egies knew in advance the number of plays and none tried to take advantage of it, it is possible
to consider the game a representation of an infinite repeated one; see Binmore 1994 and
1998.
5. Tit-for-tat strategy can be summarized as cooperate in the first play and then do exactly what
the other player did last play.
6. Rational ignorance on the part of the voter is the fact that to be informed about voting ques-
tions is very expensive for one individual, while the benefits from a correct vote are appro-
priated by the society as a whole with only a small fraction affecting the individual voter. So,
1020 Ronaldo Fiani

from a cost-benefit view it is more rational for the individual voter to remain ignorant regard-
ing political decisions.

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