The world is a complicated place. Especially when you are dealing with lots of other people, it can be very hard to predict how other people will act. And that, in turn, makes it very difficult to plan what you are going to do. Which then makes it harder for other people to predict how you are going to act, and so on.

With all of this uncertainty, how do we manage to function during the day? And just as importantly, how do we make long-term plans for the future, such as building infrastructure or growing food? As Douglass North writes in his book Institutions, Institutional Change, and Economic Performance, we use institutions to reduce the uncertainty of our interactions with other people. As a result, the structure of a society’s institutions plays a huge role in its economic and social functioning.

(If you read my book Beyond Kings and Princesses: Governments for Worldbuilders, you might remember that a good chunk of the book was inspired by Violence and Social Orders, by North/Wallis/Weingast; this is “North” of that trio.)

In a nutshell, here is North’s argument: in a vacuum, there is often too much uncertainty to permit voluntary interaction between people. Institutions are created to reduce uncertainty. Then organizations form or entrepreneurs make deals to take advantage of the possibilities created by the institutions, and the feedback from same gradually changes the institutions.

Some institutions are formal, such as laws, rules, regulations, religious doctrine, and the like. Some are informal—North identifies three kinds: (1) extensions or modifications of formal rules, (2) social norms, and (3) personally imposed standards. Either kind of institution can be created for many reasons, and formal institutions in particular often are created for self-interested reasons by those in power. As North puts it, “Institutions are not necessarily or even usually created to be socially efficient; rather they, or at least the formal rules, are created to serve the interests of those with the bargaining power to devise new rules.”

Nevertheless, institutions have the effect of reducing uncertainty, by giving us stronger beliefs about how other people will act in a given situation. Because of this, environments of high uncertainty (such as quickly changing social or environmental settings) often drive people to create new institutions, either formal systems or new belief systems.

(That need not always be socially optimal; a cultural belief that “my countrymen will deal honestly, but foreigners will always rob and murder me” would certainly reduce one’s felt uncertainty in both directions, but probably would not be helpful overall—unless the foreigners in question would actually do so!)

Reducing uncertainty has the effect of reducing transaction costs in commerce—particularly the costs of gathering information, forming agreements, and enforcing them. This is a significant issue; many of the weirdest parts of our own economy are the result of difficulties in gathering information. (Think of how hard it can be to find a job or hire people, for example.) Thus, lower transaction costs can dramatically encourage economic activity.

Okay, but what happens next? North is particularly interested in the feedback process between institutions and the people acting in light of them. In particular, entrepreneurs can sometimes perceive new opportunities that exist thanks to a given institution, take advantage of the opportunity, and therefore incrementally change the environment, creating new opportunities etc.

(For example, Jared Rubin writes about how a financial instrument first created in Muslim lands, the bill of exchange, was gleefully adopted by Christian merchants to evade currency controls between countries and served as a key impetus for the development of international banking in Europe.)

There are limits to such incremental feedback, however. North writes, “Individuals act upon incomplete information and with subjectively derived models that are frequently erroneous; the information feedback is typically insufficient to correct these subjective models.” Additionally, some institutions are designed not for economic efficiency, but to facilitate exploitation and oppression; these institutions actually raise transaction costs. Entrepreneurial adaptation can help ameliorate their effects, but only to a point. Finally, some well-meaning institutions are so flawed that no amount of adaptation can make them useful, and some kinds of adaptation can actually make them worse. (America’s short-sighted regulatory policies around housing finance, and how they sowed the seeds of the 2008 financial crisis, come to mind.)

Another key point that North makes is the importance of path dependence. In short, a given institutional environment will reward some kinds of activity and discourage others, which will in turn cause future development to lean in a particular direction. Examples:

• If there is strong rule of law and enforcement of contracts, there will be more impersonal economic exchange. If rights are weak, on the other hand, people will tend to exchange only in trusted networks. This will weaken the future development of economic networks.
• Insecure property rights will encourage the development of technologies that have low sunk costs, and are mobile. This also discourages long-term agreements.
• The advance of knowledge is in large part path-dependent. Knowledge influences ideology, which guides the search for knowledge.

And once a given institution is in place, it is often difficult to change. As W. Brian Arthur pointed out, there are at least four processes that make it less likely for people to change systems once put in place: large fixed costs; domain-specific learning; coordination effects; and adaptive expectations.

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What are some takeaways, especially for worldbuilders? First, every time that you think of some new organization or new law or new environmental condition, spend time thinking about how self-interested people will react to it—and how other people will react to them, and so on. Second, remember the importance of reducing uncertainty.

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(This post is part of Politics for Worldbuilders, an occasional series. Many of the previous posts in this series eventually became grist for my handbook for authors and game designers, Beyond Kings and Princesses: Governments for Worldbuilders. The topic of this post belongs in the planned second book in this series, working title Wealth [Commerce?] for Worldbuilders. No idea when it will be finished, but it should be fun!)