This volume is the outcome of a research project initiated by the World Bank. In recent years, the Bank has been actively supporting efforts at privatization in developing countries. For utilities in particular, it has become clear that the regulatory framework was an important determinant of the success or failure of these efforts. Yet there were important gaps in knowledge as to appropriate regulatory design across different institutional settings. Consequently, a first objective of the research project was to learn from experience as to what worked in the regulation of telecommunications – and, by extension, in utility regulation more broadly.

A second objective of the research was to probe what might be the practical relevance for World Bank work of the “new institutional economics” (NIE). Many World Bank staff were intrigued by the conceptual advances and the empirical findings emerging from the NIE research agenda – but were unclear as to the concrete implications of the intellectual advances for policy design. Some key characteristics of utilities – important economies of scale and scope, assets which can be specific and nonredeployable in other uses, and the frequent politicization of utility pricing – are presently those which have received detailed attention in the NIE literature. Consequently, there was much background work on which an applied study of regulation of telecommunications could build.

Argentina is a very recent entrant to the small group of countries with privately owned telecommunications firms – and, given its history, an unexpected one. Argentina entered this group in November 1990 when the government sold the Empresa Nacional de Telecomunicaciones (ENTeL) to private investors. Although it is too early to definitively assess the impact of this sale, the sequencing of the privatization and the development of a regulatory regime present some interesting issues.

The political situation during the transition from the administration of President Raúl Alfonsín to that of President Carlos Saul Menem in 1989 presented the Menem government with a brief opportunity to introduce radical economic reform. Privatization was a central component of this reform program, and ENTeL was the first company put on the block. The sale became a test of the Menem government's ability and resolve to reform the economy. Rapid completion of the sale was the overriding concern, and development of a regulatory regime initially was neglected.

Regulation plays an important role in the private provision of telecommunications. Portions of the sector are characterized by economies of scale, making an argument for limiting entry in the interests of efficiency. However, inadequate competition can lead to abuses of monopoly power and to demands from customers and suppliers for regulatory protection from these abuses. Standards and interconnection rules affect the efficiency of the sector. High sunk costs and asset specificity make telecommunications firms especially vulnerable to the risks of expropriation.

INTRODUCTION

Most social scientists agree that an understanding of institutions is critical for understanding economic development and the economic performance of economies. Yet, despite this recognition, the research on institutions by many social scientists is either highly descriptive or so abstract as to render it useless for policy. The reason for the absence of the “happy medium” is that few scholars know how to do empirical work in institutional economics. It is seldom taught in graduate school and the practitioners have learned by doing. It is our goal in collecting the essays in this volume to further the development of work in institutional analysis by drawing out some lessons on how to perform research.

HISTORY MATTERS

Institutions are historically specific, and for this reason it is necessary to be sensitive to historical context. This is particularly true for the dynamics of institutional change. Much of the developmental path of societies is conditioned by their past. Even after revolutions, institution builders do not start off in a historical vacuum. At any moment in time, actions are constrained by customs, norms, religious beliefs, and many other inherited institutions. This is as true for the leaders in Eastern Europe today as it was for Augustus Caesar.

An understanding of history is also important because the dynamics of institutional change frequently include unintended consequences that take on a life of their own.

History must be replete with instances where the stated intentions of legislative actions have diverged from the actual effects. However, for two reasons it is difficult to demonstrate such variance empirically in actual case studies. For one thing, legislators often tend to express their intentions in such vague terms as “to improve welfare.” How can one measure by any commonly accepted criteria how well the observable effects attributable to a given piece of legislation fulfill such an intention? Second, before observed effects can even be attributed to a given enactment, it is imperative that implications be derived which can be confirmed or falsified by facts; and this, in turn, demands sufficient information on the relevant constraints.

The rent control in Hong Kong enacted under the Rents Ordinance of 1921 presents an exceptionally useful case. The legislative intents could not have been stated more clearly: rent control was imposed to keep a roof over the heads of the sitting tenants and to encourage the construction of new buildings on vacant lands. And although most of the records were destroyed by the Japanese occupation of the colony during World War II, adequate information is still available to allow derivation of some crucial implications of the control.

THE ARGUMENTS FOR THE RENTS ORDINANCE

“The object of the Bill is to protect the tenants, not landlords,” declared the Hon. J. H. Kemp, Attorney-General of Hong Kong, on July 18, 1921, in the second reading of the Rents Ordinance Bill which passed the same day.

This article focuses on the political factors underpinning economic growth and the development of markets – not simply the rules governing economic exchange, but also the institutions governing how these rules are enforced and how they may be changed. A critical political factor is the degree to which the regime or sovereign is committed to or bound by these rules. Rules the sovereign can readily revise differ significantly in their implications for performance from exactly the same rules when not subject to revision. The more likely it is that the sovereign will alter property rights for his or her own benefit, the lower the expected returns from investment and the lower in turn the incentive to invest. For economic growth to occur the sovereign or government must not merely establish the relevant set of rights, but must make a credible commitment to them.

A ruler can establish such commitment in two ways. One is by setting a precedent of “responsible behavior,” appearing to be committed to a set of rules that he or she will consistently enforce. The second is by being constrained to obey a set of rules that do not permit leeway for violating commitments. We have very seldom observed the former, in good part because the pressures and continual strain of fiscal necessity eventually led rulers to “irresponsible behavior” and the violation of agreements. The latter story is, however, the one we tell.

THE ECONOMIC SPHERE AND THE RULE-MAKING SPHERE

The following essay by William Riker and Itai Sened analyzes a fascinating case of institutional change: the evolution of property rights in time slots (the rights to land and to take off) at four heavily used U.S. airports. In these airports, the structure of rights in slots changed in 1969 from open access and queuing on a first-come, first-served basis to communal property governed by the established carriers. In 1985 the structure changed again, to exclusive salable property rights.

Riker and Sened take their analysis beyond the naive model of property rights, which examines the behavior of only economic actors and organizations (the demand side of institutional change), and strongly emphasize the role of political actors and organizations (the supply side). In other words, the study analyzes the behavior of actors in both the economic sphere and the rule-making or public-choice sphere, but not in the constitutional sphere, since the institutional change in question did not involve new procedures for public choice.

In society, the design of formal rules for granting property rights is ultimately the domain of the actors who control the state, because they (usually) have the resources and the will to determine the basic structure of property rights in their territory. Riker and Sened assume that these political actors act rationally and grant property rights in order to promote their own welfare, broadly defined to include individual wealth, power, and social ideals.

In most societies individual private ownership of natural resources such as minerals, forests, and fisheries is rare. Unless regulated, open-access conditions will result in overuse of a resource relative to what would prevail under private ownership. Regulation of the commons faces two challenges: (1) the prevention of overuse and (2) exploitation of the resource in the least costly manner. The following essay by Robert Higgs analyzes the causes and consequences of the regulations restricting the catch of salmon in the Pacific Northwest. For the most part the focus is on the costs of regulation rather than on the issue of preventing overuse. Higgs argues that because of the anadromous nature of salmon, the least costly means of catch is the use of upstream techniques or traps at the mouths of rivers, yet legislators have generally outlawed the highly successful catch techniques. The result of the regulations, according to Higgs, is technical regress; we now harvest fewer salmon with more inputs than we did before the regulations were instituted.

Higgs's essay is rich in historical detail. As in the essay by Krueger (Chapter 5), without such historical knowledge the dynamics of regulation would be difficult to understand. For example, sport fishermen today are among the important players in the policy arena and were not a potent force when the original legislation was put in place. It is not reasonable to assume that the original designers could have foreseen the future role of sport fishermen.

RESTRICTING THE PRICE MECHANISM

Price control changes the structure of property rights and has complex economic consequences that often are unforeseen by economic actors. In a free market, before controls are instituted, prices allocate scarce resources among competing individuals according to the willingness and ability to pay. The question of who gets what is settled on the basis of individual preferences and purchasing power. However, the use of prices to ration the rights to scarce resources frequently conflicts with the selfinterest or ideologies of economic and political actors, who may seek to restrict or even abolish the price mechanism, at least in specific areas. The suspension of the price mechanism calls for some alternative method of rationing, such as direct assignment by the state, rationing by waiting, lottery, fistfights, or warfare. The alternative system of rationing can also be based on social norms and custom – which usually is the case, for example, within the family.

It is important to realize that the system used to ration economic resources affects not only the distribution of wealth in a community but also the overall level of wealth. The behavior of investors and producers is influenced by the methods used to reward them and their degree of control over inputs and outputs in production and so is also the supply of goods and services.

The authorities may interfere with the price mechanism either by subsidizing or restricting the demand and/or the supply of commodities or by directly controlling prices.

In economic theory, it is relatively straightforward to analyse the impact of government controls over economic activity. Whether the control is over feed-grain prices in Egypt, the quantities of imports of individual items in India, price controls on ‘old’ oil, or the ‘voluntary’ reduction in the number of automobiles exported from Japan to the United States, several conclusions follow straightforwardly. First and foremost, those controls (and most others) at best achieve their objectives in a more costly manner than would alternative mechanisms. Second, the presumed beneficiaries of controls are often quite different from those (if any) actually benefiting. Third, the costs of controls seem to be largely ignored or misunderstood in political decision-making, at least in the first instance.

Despite these well-established results, controls seem to persist. A major challenge confronting those concerned with their costs is to attempt to understand the reasons why the political process often generates and perpetuates high-cost solutions to stated objectives. To establish an understanding of the political economy of controls would appear to be a formidable, but important, challenge, if means are to be sought to lower the costs of attaining political objectives.

The purpose of this chapter is to attempt to further our understanding of the political economy of controls. Section i provides a survey of existing models of regulation. The remainder of the chapter is then devoted to an examination of how well those models perform in light of the history of one particular set of controls – the American sugar programme.

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.