This presentation of the main ideas and concepts of game theory required to understand the discussion in this book is intended for readers without previous exposure to game theory.

A game-theoretic analysis starts by specifying the rules of the game. These rules identify the decision makers (the players), their possible actions, the information available to them, the probability distributions over chance events, and each decision maker's preference over outcomes –specifically, the set of all possible combinations of actions by the players. A game is represented, or defined, by the triplet of the players' set, the action set (which specifies each player's actions), and the payoff set (which specifies each player's payoffs as a function of the actions taken by the players). The rules of the game are assumed to be common knowledge. The situations considered are strategic in the sense that each player's optimal strategy depends on the actions of other players. (Nonstrategic situations constitute a special case.)

The objective of game-theoretic analysis is to predict behavior in strategic situations – to predict an action combination (an action to each player) for any given rules of the game. The difficulty of finding such solutions stems from the fact that because the action optimal for each player depends on others' actions, no player can choose his optimal action independently of what other players do.

The auto joint ventures in Changchun and Wuhan, although more recently created, are also more heavily burdened by history. Changchun has long served as a key industrial base and transportation hub for northeast China. It was the capital city of the Japanese-controlled Manchukuo from 1931 to 1945, and like the rest of Manchuria, it emerged from the Japanese occupation with a relatively well-developed industrial base. The young Communist regime sought to capitalize upon these advantages when it decided to locate the First Auto Works (FAW) in the city in the early 1950s. The “auto city,” constructed with the help of Soviet advisors, was the pride of socialist China, producing sturdy blue trucks for the workers and Red Flag limousines for the leaders. By the 1990s, however, the city was at the center of China's rust belt, and the impact of the reform movement was relatively slight. While the municipal auto offices in Guangzhou were moved in the 1990s to a gleaming new skyscraper in the city's rapidly growing business district, the municipal auto offices of Changchun continued to be located in a stolid old building at no. 57 Stalin Street.

Wuhan, located at the intersection of the Yangtze River and the trunk line of the Beijing-Guangzhou railroad, has long served as a transportation link and commercial entrepot for inland China.

One of the central questions about the institutional foundations of markets concerns the power of the state. The simplest economic view of the state – as an entity that enforces contracts and property rights and provides public goods – poses the following problem: a state with sufficient coercive power to do these things also has the power to withhold protection or confiscate private wealth, undermining the foundations of the market economy.

In the medieval era, before a trading center was established a ruler might pledge that foreign merchants would be secure and their rights respected. Once trade was established, however, the ruler faced the temptation to renege on his pledge – by failing to provide the promised protection or by using his coercive power to abuse the merchants' property rights. Before the emergence of the nation-state, foreign merchants could expect little military or political aid from their countrymen. Without something tangible to secure the ruler's pledge, foreign merchants were therefore not likely to frequent a trading center – an outcome that could be costly for both the ruler and the merchants. What institutions, if any, mitigated this problem?

Trade relationships between a particular merchant and ruler consist of a potentially long sequence of trading visits, during each of which the merchant may pay tax to the ruler. Intuitively, one might conjecture that a particular reputation-based institution could have enabled the ruler to commit himself.

When the primary concern of Chinese auto firms was increasing manufacturing capability, Shanghai firms had a critical advantage: the municipal government and SAIC were able to ease the risk of individual firms and nurture the development of an entire sector. The Shanghai municipal government, to use Lindblom's memorable characterization of authority systems, was all thumbs at this stage, and that was fine. With the comfort of high tariff barriers, even relatively crude means of channeling resources into the sector would be rewarded with increased sales. Shanghai firms were able to rapidly achieve economies of scale and capture market share. The considerable profits were plowed back into the supply network, and this created the strong foundation that later allowed them to upgrade their technical capabilities.

The challenge as competition and global integration increased, however, was matching technical progress with the ability to cut costs. Cultivating a supply network of efficient firms – as opposed to merely capable – was a task that imposed far greater demands on municipal institutions for two reasons. First, the governance structures within the local business group had to be improved, so as to create mechanisms of discipline and control. Rather than simply channeling resources to all firms within the network, resources had to be allocated according to the effectiveness with which they were utilized; those firms that were operating efficiently had to receive further investment, those that were not, had to be cut off.

Long after the start of the reform period – and well after the proven success of the private sector – the fate of the state-owned sector in China continues to disturb the sleep of policymakers in the Chinese central government.

During much of the 1990s, the problem was nightmares, largely because of the government's dependence on an ever-weakening state sector. Unlike in rural areas, where the non-state sector transformed the labor force, in the politically sensitive urban areas, the state sector continued to employ a relatively stable share of the workforce until 1995. At the beginning of the reform period, SOEs employed 78% of urban workers; in 1995, despite a dramatic decrease in output, they continued to employ 65%. In urban areas the state sector accounted for half of the new jobs created between 1978 and 1995. Similarly, the SOEs, despite their declining share of output, continued to contribute 71% of the Chinese government's revenue. This dependence on state-owned firms would not have been a problem if these firms were healthy, of course, but unfortunately this was far from being the case. In 1996, the number of loss-making enterprises began to exceed the number making a profit, and the ratio of liabilities to assets for the sector as a whole was at an all-time high of 85%. Fortunately, the locus of job creation moved away from the state sector after 1995, and toward private and foreign-invested firms. It became increasingly common for SOEs to lay off or furlough (xiagang) workers.

Chapters 3 and 4 illustrate that restricting the set of admissible institutionalized beliefs is central to the way in which game theory facilitates the study of endogenous institutions. Durkheim (1950 [1895], p. 45) recognized the centrality of institutionalized beliefs, arguing that institutions are “all the beliefs and modes of behavior instituted by the collectivity.” But neither Durkheim nor his followers placed any analytic restrictions on what beliefs the collectivity could institute. Because beliefs are not directly observable, however, deductively restricting them, as game theory lets us do, is imperative. The only beliefs that can be instituted by the collectivity – that can be common knowledge – are those regarding equilibrium (self-enforcing) behavior. Furthermore, the behavior that these beliefs motivate should reproduce, not refute or erode them.

Game theory thus enables us to place more of the “responsibility for social order on the individuals who are part of that order” (Crawford and Ostrom 1995, p. 583). Rather than assuming that individuals follow rules, it provides an analytical framework within which it is possible to study the way in which behavior is endogenously generated – how, through their interactions, individuals gain the information, ability, and motivation to follow particular rules of behavior. It allows us to examine, for example, who applies sanctions and rewards that motivate behavior, how those who are to apply them learn or decide which ones to apply, why they do not shirk this duty, and why offenders do not flee to avoid sanctions.

Many contemporary countries face the challenge of building states that effectively promote political stability, curtail political violence, and foster economic prosperity. Late medieval Europe witnessed a wave of attempts to create such states, particularly in the form of the city-states of northern Italy (see, e.g., Waley 1988). No microanalytical examination of this process of state building has been conducted, and its lessons have not been uncovered.

This chapter examines the state-building process in the city-state of Genoa, which emerged from obscurity to become one of the wealthiest cities in Europe but whose history was characterized by frequent intracity political violence and later also by relative economic decline. This Chapter provides a microanalytical examination of the historical process of state building in Genoa, explicitly studying the polity as an equilibrium outcome in which actors can choose between predatory and economic behavior.

Two perspectives dominate the study of the relationships between political institutions and economic prosperity, neither of which adequately accounts for Genoa's experience. The first perspective assumes the existence of a predator-ruler, a ruler with a monopoly over coercive power. According to this view, promoting prosperity entails building institutions that enable the ruler to credibly commit to respecting property rights. This perspective cannot be applied to the city-state of Genoa, which had no de facto ruler with or without a monopoly over coercive power at the time it was established.

Scholars in economics, political science, and sociology use various definitions of the term institution. Sections 2.1 and 2.2 of this chapter define the term in a precise manner in order to delineate the scope of the analysis. Particular rules, beliefs, norms, and organizations are central to this definition, which helps illuminate why institutions have such a profound impact on behavior and how they should be studied analytically (Part II), why they persist in a changing environment and why they exert an independent impact on institutional dynamics (Part III), and how to study them empirically (Part IV).

The definition presented here encompasses other seemingly alternative definitions. It fosters the development of a unifying concept of the object of study and the integration of insights and analytical frameworks developed in conjunction with various definitions of institutions (section 2.3). The definition also highlights the sense in which transactions are the basic unit of institutional analysis, although this requires defining transactions in a more comprehensive manner than traditionally done in economics. Intertransactional linkages are central to institutions because, among other reasons, the institutionalized beliefs and norms that motivate behavior in a particular transaction reflect what other transactions were linked to it and in what way, while organizations are reflections of and means for linking transactions (sections 2.4 and 2.5).

While reading this chapter it is useful to keep in mind what it is not about. It does not examine the origin of institutions or why and how they change.

Theory is unavoidable in positive institutional analysis. Implicitly or explicitly, a student of institutions resorts to theory to guide the selection of issues and to identify relevant factors and causal relationships. Theoretical assertions about the importance of exchange, polities, and the harnessing of coercive power direct the investigation of the institutional foundations of agency relationships, property rights security, impersonal exchange, and the mobilization of resources for collective action. Theinvestigation itself is directed by a concept of institutions central to which are intertransactional linkages and the associated institutional elements, self-enforceability, and the nature of institutional development as a historical process. Game theory tells us what to look for in considering and evaluating the self-enforceability of institutional elements in a given environment.

Theory also makes another important contribution. By pointing to the general principles that underpin the operation of institutions that can lead to a particular outcome, theory indicates that institutions – and the history they induce – are not random. Context and contingency are important, but institutions generating similar behavior in the same central transactions are subject to the same forces and have to respond to the same considerations regardless of the particularities of time and place. Institutions that achieve the same outcomes have to mitigate the same problems that are implied by the inherent attributes of the central transaction under consideration and by the general context.

The inherent indeterminacy and context-specificity of institutions challenge our ability to study them using the traditional social science empirical methods. These methods rest on the premise that, given a set of exogenous and observable features of a situation, deductive theory can sufficiently restrict the outcome set to render a positive analysis meaningful. In the case of endogenous institutions, we lack such a theory.

Parts I–III highlight several reasons why it may be impossible to develop a deductive theory of institutions. Institutions are inherently indeterminate and context-specific. Various transactions can be linked to a central one, and multiple equilibria – and hence institutions – can prevail in the repeated situations that are essential to institutional analysis. Different institutions embodying distinct cognitive models and information can be self-enforcing. Institutional change is a function of the prevailing institutions, while its direction is influenced by institutional elements inherited from the past. Whether or not a deductive theory of institutions will ever be developed, our current state of knowledge is such that we cannot understand institutions relevant in a particular time and place by relying solely on deductive theory.

Inductive analysis à la Bacon, which identifies and classifies institutions based on their observable features alone, is similarly deficient for studying institutions. Pure induction is insufficient because various institutional elements, such as beliefs and norms that motivate behavior, are not directly observable.

On March 28, 1210, Rubeus de Campo of Genoa agreed to pay a debt of 100 marks sterling in London on behalf of Vivianus Jordanus from Lucca. There is nothing unusual about this agreement – in fact, there is evidence of thousands of such agreements in Europe at the time. But this agreement implicitly reveals why Rubeus lived in a period of remarkable economic growth measured by such proxies as urbanization, population growth, capital investment, and changing patterns of trade.

First, this agreement reflects well-functioning markets. The institutional foundations of these markets were such that merchants trusted agents to handle their affairs abroad, even without legal contracts. Impersonal lending among traders from remote corners of Europe prevailed, and property rights were sufficiently secure that merchants could travel abroad with their riches. Second, it reflects well-functioning polities. The institutional foundations of polities throughout Europe during this time induced policies that were conducive to economic prosperity. Rubeus made his agreement in the Republic of Genoa, which had been established about a century earlier but had already pursued policies that made it a bustling commercial center. To understand why and how such well-functioning markets and polities came about in various historical episodes and what led to their persistence and decline, we have to study their institutional foundations.

Studying institutions sheds light on why some countries are rich and others poor, why some enjoy a welfare-enhancing political order and others do not. Socially beneficial institutions promote welfare-enhancing cooperation and action.

The rise of China as a manufacturing power has corresponded to profound shifts in the global economy. In the early 1980s, when a consensus began to emerge among policymakers in Beijing that the automotive industry should be the target of industrial development efforts, the environment was a familiar one for a developing country in East Asia, and it was one that centered around the nation-state: the domestic market was heavily protected, linkages to foreign markets and technology were critical, but tightly controlled, and the state was receptive to playing an active role in the development process. As the development process gathered steam in China, the integration of national economies picked up speed and intensity. World export volumes continued to increase, but it was international production that was becoming the primary driver of the global economy and economic development. Whereas in 1980, foreign direct investment inflows formed 11.7% of gross domestic capital formation in manufacturing in developing countries, this number had increased to 36.7% by 1998. There was a slight decline in total FDI flows to the developing world after 2000, largely as a result of declining flows to middle-income Latin American countries, but the flows to China continued to increase, and in 2003 it became the top destination for FDI in the world. The global economy was increasingly becoming a single market for goods, services, capital, and labor, and China was its poster child.