A free market system makes better use of the inherently dispersed knowledge within the economic realm. It also makes for a more efficient allocation of scarce resources.
In textbooks, economics is often defined as the study of the allocation of scarce resources among competing ends. Douglass North says that adaptation is more important than allocation.These flexible institutions allowed for the creation and adoption of innovations both technological and social.
"It is adaptive rather than allocative efficiency which is the key to long run growth. Successful political/economic systems have evolved flexible institutional structures that can survive the shocks and changes that are a part of successful evolution. But these systems have been a product of long gestation. We do not know how to create adaptive efficiency in the short run."
-- Douglass C. North, Economic Performance Through Time, the 1993 Economics Nobel Prize lecture
Douglass North's primary field is economic history, and his primary interest is in economic change. In fact, the word "change" appears in the title of many of his works. For North's purposes, the study of allocation mechanisms is inadequate.Some of the really interesting stuff in economics involves peoples attempts to cope with uncertainty. Frank Knight claimed that this can not be modeled.
[textbook] economics applied to economic development or economic history may account well for the performance of an economy at a moment of time or...contrasts in the performance of an economy over time; but it does not and cannot explain the dynamics of change. The major source of changes in an economy over time is structural change in the parameters held constant by the economist -- technology, population, property rights, and government control over resources.
-- Structure and Change in Economic History, p. 57
For agriculture to work well, property rights must be defined. To reach the stage that we call modern economic development, rules need to cover trading rather than basic sharing.It seems like a shakeup of the social order has lingering effects to this day.
In short, what is required is a shift from a status-based and coercive society that relies on mutual control, respect of ranks, and strictly enforced codes of generosity, to an open society where free entry and exit, democratic governance (including acceptance of dissent), competence criteria, and socioeconomic differentiation are used as guiding principles or expressly allowed to operate.
While market prices are necessary to enable an economy to process this information (a point stressed by Ludwig von Mises and Friedrich Hayek), they are not sufficient, according to Douglass North.
The integration of this specialized knowledge with low costs of transacting requires more than an effective price system. Institutions and organizations were necessary to supplement the price system where externalities, information asymmetries, and free rider problems had to be overcome. The increasingly dispersed knowledge of modern societies requires a complex structure of institutions and organizations to integrate and apply knowledge...The growth of knowledge is dependent on complementary institutions which will facilitate and encourage such growth and there is nothing automatic about such development.
--Understanding the Process of Economic Change, p. 99
Douglass North calls attention to the relationship between the private rate of return on innovation and the social rate of return. The social rate of return from innovation is always high, but the private rate of return can easily be low. Innovation takes place when the private rate of return is sufficiently high. Institutional arrangements determine the private rate of return from innovation, and hence they determine a society's adaptive efficiency.
Two important institutional factors are property rights and capital markets. We have just seen how North views the development of the patent mechanism for protecting intellectual property as a cornerstone for modern economic development. On capital markets, he writes,
economic change will require continual alteration in the institutional structure in order to maintain efficiency. This is particularly critical for capital markets...The history of Japan in the 1990's is a classic instance of a capital market that initially fueled extraordinary development--that of post-World War II--only to develop the sclerosis that followed.
--Understanding the Process of Economic Change, p. 123-124
One reason that institutions evolve slowly is that organizations have developed with a vested interest in existing practices. Another reason is that institutions reflect the beliefs shared by a culture. North places a heavy emphasis on the role of beliefs in shaping institutions, which in turn determine economic outcomes.Both rent seeking special interests and the established political class can make change quite difficult. Think - eliminating agricultural subsidies.
Mancur Olson addresses uncertainty, innovation, adaptation and institutions in the conclusion of his final book, Power and Prosperity:
Because uncertainties are so pervasive and unfathomable, the most dynamic and prosperous societies are those that try many, many different things. They are societies with countless thousands of entrepreneurs who have relatively good access to credit and venture capital. There is no way that a society can predict the future, but if it has a wide enough array of mutually advantageous transactions, including those for credit and venture capital, it can cover a lot of the options - more than any single person or agency could ever think of.Contrary to what collectivists would have us believe, effective institutions that harness private incentives provide a big payoff to us all!
At least when a society has the appropriate institutions and government policies, the overwhelming majority of the firms that make huge profits are doing a huge service to the population. In a society with the right institutions and public policies, the prevailing prices will approximate the true values and costs of marginal quantities of the goods and productive inputs. A great excess of revenues over costs means that the enterprise is almost certainly putting more value into the society than it is taking out.