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Economic change is a ubiquitous, ongoing, incremental process that is a consequence of the choices individuals and entrepreneurs of organizations are making every day. While the vast majority of these decisions are routine (Nelson and Winter, 1982), some involve altering existing “contracts” between individuals and organizations. Sometimes that recontracting can be accomplished within the existing structure of property rights and political rules, but sometimes new contracting forms require an alteration in the rules. Usually existing informal norms of behavior will guide exchanges, but sometimes such norms will gradually be modified or wither away. In both instances institutions are gradually being modified. Modifications occur because individuals perceive that they could do better by restructuring exchanges (political or economic). The source of the changed perceptions may be exogenous to the economy — for instance, a change in the price or quality of a competitive product in another economy that alters the perceptions of entrepreneurs in the given economy about profitable opportunities. But the fundamental source of change is learning By entrepreneurs of organizations.

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While some learning is a result of idle curiosity, the rate of learning will reflect the intensity of competition amongst organizations. Competition is a ubiquitous consequence of scarcity, and hence organizations in an economy will engage in learning to survive. If competition is muted as a result of monopoly power, the incentive to learn will be reduced.
The rate of learning determines the speed of economic change; the kind of learning determines the direction of economic change. If the institutional matrix rewards piracy (or more generally redistributive activities) more than productive activity, then learning will take the form of learning to be better pirates.
Change is typically incremental, reflecting ongoing ubiquitous evolving perceptions of the entrepreneurs of organizations in the context of an institutional matrix that is characterized by network externalities, complementarities and economies of scope among the existing organizations. Moreover, because the organizations owe their existence to the institutional matrix, they will be an ongoing interest group to assure the perpetuation of that institutional structure — thus assuring path dependence. Revolutions do occur, however, when organizations with different interests emerge (typically as a result of dissatisfaction with the performance of existing organizations), and the fundamental conflict between organizations over institutional change cannot be mediated within the existing institution framework.
Path dependence means that history matters, that the choices we make today and tomorrow are constrained by the past evolution of the belief systems and institutions of the society.

POLICY GUIDELINES
The foregoing description of the characteristics of economic change is clearly incomplete as a guide to policy in improving the performance of economies, but it does suggest the direction we must go in further research and the issues that are relevant to improving economic performance.
1. Because institutions are made up of formal rules, informal norms and the enforcement characteristics of both, it is the combination of rules, norms, and enforcement characteristics that determines economic performance. While the formal rules can be changed overnight, the informal norms change only gradually. Because it is the norms that provide the essential “legitimacy” to any set of formal rules, revolutionary change is never as revolutionary as its supporters desire and performance will be different than anticipated. Because we have only very incomplete understanding of how norms change, we are not able to predict the outcome of changes in formal rules. But we do know that societies that adopt the formal rules of another society (such as Latin American countries’ adoption of constitutions like that of the United States) will have very different performance characteristics than the original country, because both the informal norms and the enforcement characteristics will be different. The implication is that transferring the formal political and economic rules of successful western market economies to third world and eastern European economies is not a sufficient condition for good economic performance. Privatization is not a panacea for solving poor economic performance.
2. It is polities that shape economic performance, because they define and enforce the economic rules of the game. But, as noted in the previous section, political markets are inherently less efficient than economic markets. From Madison’s cautions in Federalist Paper number 10 to Arrow’s impossibility theorem, we have ample warning of the problems of creating a representative polity. Yet economists, until recently, have ignored the politics of economies. We know little enough about maintaining effective polities in the developed economies that have the immense advantage of a long gestation period to evolve stable political norms. But how to create stable polities that will undergird effective economies in a short period of time is beyond our current state of knowledge. We know a lot about the characteristics of the polities of third world countries, but we have very little theory about such polities. We know even less about the consequences of radically altering the institutional framework of central and eastern European societies. However, the characteristics of institutions described in the foregoing sections of this paper suggest some implications:
a. Political institutions (rules that specify the structure and decisionmaking framework of the polity) will be stable only if they are supported by organizations with an interest in their perpetuation. Therefore an essential part of political/economic reform is the creation of such organizations. Such political organizations will have the coercive power to specify and enforce the economic rules.
b. It is essential to change both the institutions and the belief systems for successful reform, because it is the mental models of the actors that will shape choices. Therefore belief systems and the way they evolve will be the ultimate determinants of the institutional matrix.
c. Evolving norms of behavior that will support and legitimize new rules is a lengthy process and in the absence of such reinforcing norms polities will tend to be unstable.
d. While economic growth can occur in the short run with autocratic regimes, long-run economic growth entails the development of the rule of law and (probably) the protection of civil and political freedoms.
e. Informal constraints — norms of behavior, conventions, and codes of conduct — are a necessary (but not sufficient) condition for good economic performance. Societies with norms favorable to economic growth can sometimes prosper even with unstable or adverse political rules. The key is the degree to which there is enforcement of the adverse political rules. We know very little about the evolution of belief systems and consequent informal constraints, although religions have clearly been a basic component of belief systems.
3. Understanding the interaction between changing institutions, the consequences for the welfare of the diverse groups of participants in a society, the resultant perceptions of the diverse groups, the degree of access of diverse groups to political expression, and in consequence the political repercussions of the changed institutions that will lead to subsequent institutional change requires a dynamic modeling of these changes through time. It is thinking in these dynamic terms rather than static “one shot analysis” that is essential for good policy. Until we explicitly evolve such models in the context of intimate knowledge of the (path dependent) characteristics of individual economies, we will fail to achieve the desired results.
4. Path dependence means that the degrees of freedom that policy makers possess to alter the direction of economies are constrained by the institutional matrix and the belief systems of the players. Of all the implications of institutional analysis for policy, this is the most important. The implicit assumption of neoclassical theory that institutions don’t matter and can be ignored in policy prescription is itself a prescription for disaster.
Allocative efficiency is a static concept with a given set of institutions; the key to continuing good economic performance is a flexible institutional matrix that will adjust in the context of evolving technological and demographic changes as well as shocks to the system. It is the creation of a stable polity with complementary norms that is the essential characteristic. Successful political/economic systems have evolved such characteristics over long periods of time. The western world, for example, evolved stable political and economic institutions over hundreds of years. However it is doubtful if the policies that will produce allocative efficiency are always the proper medicine for ailing economies. Efficient policies that are perceived to be inequitable will engender political reactions that can stall or reverse effective reforms.
The foregoing “laundry list” of the shortfall in our understanding of the dynamics of economic change should be a humbling reminder to economists of just how far we have to go before we develop a body of theory that will allow us to confront squarely and resolve the economic issues of the world we live in.

FOOTNOTES
1 See my Structure and Change in Economic History (New York: Norton, 1981) Ch. 13 “The Second Economic Revolution” for an elaboration of this argument.

REFERENCES
Hahn, Frank, “The Next Hundred Years,” The Economic Journal, 101 (Jan. 1991), pp. 47-50.
Nelson, Richard and Winter, Sidney G., An Evolutionary Theory of Economic Change, (1982), Cambridge, MA: Harvard University Press.
North, Douglass C., Structure and Change in Economic History, (1981), New York: Norton.
Simon, Herbert, “Rationality in Psychology and Economics,” in Robin M. Hogarth and Melvin W. Reder, eds., Rational Choice: The Contrast Between Economics and Psychology, (1986), Chicago: University of Chicago Press, pp. 25-40.
Wallis, John J., and North, Douglass C., “Measuring the Transaction Sector in the American Economy,” in Stanley L. Engerman and Robert E. Gallman, eds., Long-term Factors in American Economic Growth, (1986), Chicago: University of Chicago Press, pp. 95-148.
Douglass C. North is Luce Professor of Law and Liberty in the Department of Economics, Washington University, St. Louis, MO. He received the 1993 Nobel Prize in Economic Science.
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