The history of the Washington salmon fishery is a legal and economic horror story. When the whites first encountered the flourishing aboriginal fishery, they failed to recognize the virtues of its technical and, in a certain sense, legal organization. Determined to transform into private wealth an immensely valuable natural resource, they rushed to appropriate the salmon fishery and threatened its survival. The state's voters, legislators, and appointed managers of the fishery, where the salmon ostensibly “belonged” to all the citizens of Washington collectively, would not permit outright destruction of the resource. But their response to the threat of overfishing was neither to limit entry into the fishery nor to create and enforce a private property right in it, something the Indians had approximated before the advent of the whites. Rather, the state's solution was to limit the harvest by penalizing or prohibiting the more productive harvesting techniques. In the Washington fishery today fewer than 10,000 commercial fishermen, aided by many millions of dollars' worth of fishing gear, harvest about 6 million salmon annually. Before World War I a similar number of men, working with much less than the modern amount of capital, normally harvested three to four times more salmon each year. Thus, commercial fishing productivity is now only a small fraction of what it was 70 years ago. This technical regress did not have to happen; in no sense was it inexorable.

Regulation is an integral part of institutional change. Regulation sets the rules of the economic game and thereby the incentives faced by the actors. There are several general theories of economic regulation, each fraught with difficulties when one examines the life – and rarely death – of any particular regulation. Finding fault with general theories of regulation, Anne Krueger espouses the case study approach, arguing that we could learn more by amassing historical detailed studies of specific regulation and then generalizing from the results.

Until the pioneering article by Stigler, the dominant view among economists was that market failure calls for regulation. Even today, the standard textbook treatment of externalities and monopoly begins by pointing out the inefficiencies associated with market failure and almost naturally leads students to the conclusion that government intervention is warranted. We label this the public interest paradigm. As Krueger states in this essay, “Underlying these sets of policy prescriptions is the notion of government as a benevolent guardian hampered only by ignorance of proper economic policy as it seeks disinterestedly to maximize a Benthamite social welfare function.”

The Stigler view of regulation followed in the footsteps of Olson, positing that special interest groups have lower costs of organizing and demanding regulation in their self-interest. This position has led to the view that special interest groups “capture” the regulators. Taken to its extreme, this view suggests that because special interest groups benefit ultimately from regulation, they must be the ones who are responsible for the origins of the regulation.

Institutional change takes place within an institutional framework. In short, not everything is up for grabs all at once. In the following essay, Lee Alston and Joseph Ferrie are careful to specify which institutions are constraints to everyone and which institutions are choice variables to some actors and constraints to others. Alston and Ferrie argue that the institution of social control in the U.S. South – the laws and customs in the South that resulted in a lack of civil rights and condonement of violence – increased the value to agricultural workers of having a protector/ employer. Augmenting the value of a protector was the absence of a federal welfare system that would have substituted for some of the value of a paternalistic employer. The reader should note that in the Alston–Ferrie framework social control and the absence of a federal welfare system placed constraints on agricultural labor but also served as choice variables for the very people who were protectors – the politically powerful agricultural elite. The federal welfare net ultimately expanded as a result of technological changes that changed the economic incentives faced by the Southern elite; it no longer paid the South to block the demands of Northern liberal politicians. The essay highlights how institutions give rise to incentives in contracts and also how the dynamics of an economic system can lead to institutional changes.

THE SOVEREIGN'S DILEMMA

Consider an absolute ruler who controls a country with the aim of maximizing her wealth while protecting her own security. The picture may be a simplification, but it bears resemblance to the behavior of many rulers in history. The ruler faces a dilemma:

1. She can collect the subjects' resources beyond their basic subsistence needs and maximize her wealth in the short run; or

2. she can extend her horizon, lower the rate of taxation, leave resources with the subjects, and take measures to encourage private investments that expand the economy and thus increase her tax base. In future years a larger tax base will yield greater revenue.

Whether alternative 1 or 2 will maximize the present value of the ruler's expected flow of income in future years depends on a host of factors, which are summarized in the subjective interest rate that she uses to discount the future. For instance, if the ruler is old and has no heirs or favored successors, she may not be interested in future revenues and may heavily discount future income. Similarly, the ruler may fear that giving her subjects freedom and control of resources beyond bare necessities may lead them to rebel rather than to invest. Also, if attacks from neighboring states are imminent, the ruler's maximization calculations may suggest that her best alternative is to plunder the economy, particularly if she does not have access to effective capital markets.

Economists generally treat institutions as exogenous and examine their impact on the economy. But institutions, which define the “rules of the game” in an economy and the payoffs to pursuing different strategies, can change over time. Understanding the forces that prompt changes in institutions and how the payoffs to strategies change in response to institutional changes is important for understanding the developmental pattern of societies. For example, explicit contracts may be the most efficient means of structuring transactions under one institutional regime, but less formal agreements with entirely different enforcement mechanisms may be most efficient under another. Different ways of structuring transactions may lead to different growth paths.

In this paper we examine the rise and decline of paternalism in Southern labor relations. By “paternalism” we mean an implicit contract whereby workers exchange dependable labor services for a variety of goods and services. “Dependable” implies a long-term commitment to an employer that transcends the textbook notion of spot-market exchange. In return, workers receive such goods and services as credit, housing, medical and old-age assistance, and most importantly, protection from acts of violence. Paternalism, we argue, emerged along with a particular institution – the system of social control that emerged in the late 19th century and characterized the American South during the first half of the 20th century.

The structure of property rights critically affects economic outcomes by influencing the incentives of actors to create new wealth or to dissipate resources. In the economics of institutions, the term property rights refers to an actor's rights, which are recognized and enforced by other members of society, to use and control valuable resources. The control over resources also has an internal component. Various rules, and their enforcement by political organizations and by custom and social norms, provide external control, but usually actors also invest privately in control, depending on how much external enforcement the community provides. Although governments, for instance, outlaw breaking and entering and provide enforcement through the police and the courts, the level of external protection varies across polities, as does the level of trespassing. Owners respond by investing in various amounts of internal enforcement – with locks on doors, burglar alarms, guard dogs, and other measures. However, economies of scale make well-functioning social control, with formal and informal rules, a much more effective arrangement than heavy reliance on private (internal) control, and the economics of institutions pays much attention to the origins and nature of property rights because of their potential significance for economic prosperity and the creation of wealth.

The following essay by Gary Libecap is a case study of the determinants of mineral law in the western United States in the nineteenth century – a study of the evolution of property rights to mineral deposits.

INTRODUCTION

How do complex, nontransparent laws and regulations and a somewhat inaccessible, expensive, and slow set of formal legal conflict resolution mechanisms affect business transactions? This study uses the approach of the new institutional economics (NIE) to contrast the impact of the complex legal and regulatory environment in Brazil with that in Chile, where regulatory and legal reforms have sought to facilitate market efficiency. In addition, the study examines the importance of legal and regulatory obstacles to the growth and operation of Brazilian businesses relative to other constraints. The results illustrate a central point: institutions matter economically in the actual costs (and benefits) they create for businesses, not in their compliance with ideal forms.

The study examines four basic areas where legal and regulatory institutions could create critical obstacles to efficiency:

• the start-up of a new business (entry);

• the regulation of business;

• orders by customers; and

• sales with credit.

The first two areas involve transactions between a business and the government, while the second two involve transactions between businesses. Interviews with garment firms were used to ascertain in as quantitative a way as possible the costs and problems associated with particular transactions.

The results show that Chilean business transactions indeed benefit from legal simplicity and consistency of enforcement relative to their Brazilian counterparts, but these benefits are mitigated by the differences between formal law and the law in practice in Brazil.

Property rights enable private persons or groups to control resources that might otherwise be controlled politically. That these rights (to use, sell, rent, profit from, and exclude others from) exist and are recognized means that rulers allow persons other than themselves to exercise control over valuables. In the abstract this is a puzzling fact. Why should rulers, with their supposed monopoly of force, leave great treasure in hands other than their own? Yet they do, and, presumably, they have good reason to do so. To identify their reason is to provide a partial explanation, at least, of the origin of property rights.

Traditional justifications of property rights ordinarily include some reference to origins. Unfortunately, many descriptions of origins devised for justificatory purposes are not historically or scientifically convincing and thereby weaken the justifications. To remedy this weakness, we set forth a positive explanation of rulers' motivations to grant property rights and citizens' motivations to petition for them and to respect them. We illustrate our theory with a contemporary example so that it, unlike most other discussions of origins, can be checked against easily available detail.

But first a caveat. Our purpose is not to debate the philosophical justification of rights. We recognize, of course, that despite our self-imposed restrictions, our theory may have implications for these justifications that depend crucially on incomplete descriptions of origins.

In recent years scholars and policy makers alike have paid increasing attention to the complex relationship between social institutions and economic performance. There are various reasons why it is important to understand the role of institutions: economic stagnation in many developing countries; structural problems in the old industrial economies; and the collapse of the soviet economies of the former Soviet Union, Central Asia, and Eastern and Central Europe. Institutional analysis is of paramount importance for guiding the transition to markets in formerly centrally managed economies. Many scholars now recognize that mainstream economic analysis, neoclassical economics, is of little help in restructuring economies that lack secure markets; the same criticism holds for other disciplines in the social sciences.

An interdisciplinary research program that deals explicitly with the link between institutions, institutional change, and economic performance is now emerging. The new institutional analysis is a line of investigation that departs from but does not abandon neoclassical economics. Central to the research agenda is an emphasis on property rights, the transaction costs of measurement and enforcement, and incomplete information. The research program has been further enriched through cross-fertilization with law, political science, sociology, anthropology, and history.

Although both theoretical and empirical contributions to this field are accumulating at an increasing rate and two pioneers of the approach recently received the Nobel Prize in Economics (R. H. Coase in 1991; D. C. North in 1993), the impression persists that the field is long on theoretical analysis but short on empirical work.

Institutions in society provide the rules of the game that determine the incentives for individuals to engage in growth-enhancing or redistributive activities. Institutions are both formal and informal. Formal institutions consist of the laws and regulations of a society. Informal institutions are the norms and customs of a society. Both impose constraints on behavior. The question addressed by Andrew Stone, Brian Levy, and Ricardo Paredes in the following essay is: To what extent do laws and regulations that ostensibly increase transaction costs in fact affect the costs of doing business? Or, put another way, in the presence of high formal transaction costs do businesses adopt informal institutions to lessen the burden of regulations? The work is innovative both theoretically and empirically. Theoretically, the authors recognize the interconnection and potential substitutability between formal and informal institutions. Empirically, they measure the effect of formal regulations by conducting field surveys in the garment industry in Brazil, a country noted for its regulations, and Chile, a country that has recently deregulated to a large extent.

The degree to which formal rules constrain behavior depends on enforcement. Enforcement is effected by the coercive power of the state or by the norms of society. Coercion and norms are substitutes. If the members of a society generally agree that something is not appropriate behavior – for example, littering – society must expend fewer resources in enforcing laws against littering.

Economic history is about the performance of economies through time. The objective of research in the field is not only to shed new light on the economic past but also to contribute to economic theory by providing an analytical framework that will enable us to understand economic change. A theory of economic dynamics comparable in precision to general equilibrium theory would be the ideal tool of analysis. In the absence of such a theory we can describe the characteristics of past economies, examine the performance of economies at various times, and engage in comparative static analysis; but missing is an analytical understanding of the way economies evolve through time.

A theory of economic dynamics is also crucial for the field of economic development. There is no mystery why the field of development has failed to develop during the five decades since the end of the Second World War. Neoclassical theory is simply an inappropriate tool to analyze and prescribe policies that will induce development. It is concerned with the operation of markets, not with how markets develop. How can one prescribe policies when one doesn't understand how economies develop? The very methods employed by neoclassical economists have dictated the subject matter and militated against such a development. That theory, in the pristine form that gave it mathematical precision and elegance, modeled a frictionless and static world.

The Cambridge Political Economy of Institutions and Decisions series is built around attempts to answer two central questions: How do institutions evolve in response to individual incentives, strategies, and choices, and how do institutions affect the performance of political and economic systems? The scope of the series is comparative and historical rather than international or specifically American, and the focus is positive rather than normative.

The nine path-breaking empirical studies in this volume capture the state of an important field, institutional analysis, in rapid transition. Institutional analysis focuses directly on the connection between institutions and economic performance. It emphasizes incomplete information and the costs of measuring performance and enforcing property rights. Unlike other books on property rights that deal specifically with particular political problems (e.g., the commons), regions (e.g., the developing world), or types of property (e.g., intellectual), this volume is concerned with property rights in general. It stresses the importance of history and the significance of adjustments on unanticipated margins. Several chapters document the creation of new political institutions, public policies, and forms of contract, all important kinds of institutional change, while the remainder explain the costs of extant regulations. The result is an impressive array of studies showing what we know about the origins and effects of institutions, which create the incentive structures in societies.

Like the earlier collections in this series, Perspectives on Positive Political Economy and Modern Political Economy, this one addresses both organizational development and the interaction between existing institutions and outcomes.

INTRODUCTION

In analyzing the disequilibrium characteristics of contemporary Western economies, Mancur Olson (1982; 1984a; 1984b) agrees with the neoclassical macroeconomists in finding that, given the tendencies of markets to clear and given the rational expectations of economic agents, any disequilibrium indicates that all mutually advantageous transactions have not been consummated. Having made this point, however, he asks what can make agents ignore the potential gains from unconsummated transactions and turns his attention toward the structure of incentives, and thus of institutions and policies. Olson insists, and rightly so, that a satisfactory static and dynamic macroeconomic theory has to explain who, among key actors, has the incentive to generate economic growth and equilibrate the economy and who does not. Furthermore, no government, even an authoritarian one, has an incentive to generate serious recessions or disequilibria. Olson (1984a, 637) writes that “even in dictatorial systems, the dictator has an incentive to make the economy of the country he controls work better, since this will generate more tax receipts he can use as he pleases and usually also reduce dissent.”

Olson's arguments about incentives, institutions, and disequilibria offer an ideal basis for an inquiry into why reforms fail in Soviet-type economies (STEs). In Olson's theories of incentives, the old Roman principle of criminal law cui prodest (who gained) is applied to modern economies, and the results suggest that, contrary to widespread opinion, it is not necessarily the “small but powerful group of high and highest leaders” that stands to gain most in terms of power and privilege from “the preservation of the existing order.”

Much of American legal activity during the eighteenth and nineteenth centuries centered on the transfer of a continent of natural resources – agricultural land, water, timber, mineral deposits – from public to private control. That transfer was crucial for the development of an economic system based largely on private incentives and market transactions. Legal policy at both the state and federal level regarding natural resource ownership and use has been the focus of work by Paul W. Gates, Willard Hurst, Harry Scheiber, and others. Those studies have generally been aimed at describing the nature and impact of governmental support for private economic activities. This paper is concerned with a somewhat different question – the timing and emergence of particular legal institutions (laws and governments). The framework for the study is that offered by Lance Davis and Douglass North in Institutional Change and American Economic Growth. There they hypothesize that institutions develop in response to changing private needs or profit potentials: “It is the possibility of profits that cannot be captured within the existing arrangemental structure that leads to the formation of new (or the mutation of old) institutional arrangements.” Essentially the same model of institutional change is used by some American legal historians, notably Lawrence Friedman and Willard Hurst. They argue that the law can only be understood by examining the surrounding economic, political, and social conditions. Those conditions mold the law, and as they change, they force legal institutions to change.