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.

REFORMING THEORIES OF REFORM

According to the modern theory of institutions, two factors are critical to the performance of an economic system: the information held by the various actors and their incentives. Yet in the past and even in our times, scholars have frequently ignored these factors in their proposals for reform.

In 1908 the Italian scholar Enrico Barone published an article entitled (in translation) “The Ministry of Production in the Collectivist State.” Barone's article encouraged economists and other social scientists to follow a path that took them away from the central issues of information and incentives. Barone, a pioneer in mathematical modeling, used his tools to establish a formal equivalence between the basic categories in a market economy based on private ownership and those in a socialist economy managed by a central authority. In the two instances, optimization involved solving a comparable set of equations.

Barone's vision of the fundamental issues of an economic system has been shared by many scholars in the twentieth century. In the 1930s the famous Lange–Lerner blueprint of a managed economy envisioned a system of “market socialism” where a central planning bureau (CPB) balanced supply and demand by using a trial-and-error method to set prices. The managers of the state-owned enterprises were to be given instructions hailing from Econ 101: (a) pick a combination of productive factors that minimize average costs and (b) set marginal costs equal to the prices determined by the CPB.

Agenda rules

In chapter 6 it appeared that bureaucratic supply induced a good deal of stability in the model of the budgetary game as it was presented in the opening section. As far as public goods are concerned, the model is able, in principle, to explain stability, provided that bureaucratic price discrimination is possible.

The stability question remains to be answered for the cases in which bureaucratic supply does not induce stability. This is the purpose of the present chapter. One must then think of services with unevenly distributed benefits such as minority private and group goods, and of public goods in situations where price discrimination is not possible.

In the initial analysis of political decision-making, it was mentioned that budgetary games generally lack cores or other stable solutions, so that attention has to be focused on the institutions of the budgetary process. Institutions are, of course, not an invention of economic theory. Indeed, the importance of rules that lead to the selection of a small group of ‘feasible’ proposals before any political decision-making in the proper sense starts, has since long been recognized in the organizational process branch of budgetary theory: recall, for instance, the notion of ‘taking the base for granted’ as a major ingredient of the organizational process perspective on budgetary decision-making. In this light, the recent upswing of interest in the institutional aspects of collective decision-making among economists can be interpreted as a late recognition that the organizational process theorists have been looking at the crucial factors all along. However, this interpretation must be qualified in two respects.

Elements of game theory

Political authorities are often collective bodies: cabinets, councils, houses of parliament, etc. The analytical tools for the study of interaction among members of collective bodies will be taken from the theory of games, especially from the theory of a specific type of n-person game that will be introduced and described in the present section and that will be called a ‘budgetary game’. In the next section some additional concepts with respect to budgetary games will be defined, namely those of the preference set, the dominant set and the Pareto superior set. With the help of these concepts it will be possible to review in the following sections some elementary game-theoretic results and to consider the consequences of these results for the problem of stability in budgetary games.

Up to this point the theory of public demand has been considered only at the level of the individual politician. In reality, we observe collective bodies. These bodies do not only decide for themselves but for all citizens of government. This state of affairs raises the question of how individual politicians interact with one another as members of a committee in the process of reaching decisions, and this question leads to the analysis of collective decision-making in the proper sense. As it turns out, game theory is an almost indispensable analytical tool when entering this domain.

The required elements of game theory will be introduced in a way that is understandable to the reader who has no prior knowledge.

Public and private goods

An important building block for the theory of legislative demand is the distinction between ‘public goods’ and ‘private goods’. The term ‘public good’ will be used in this book for an economic good that can, and does, benefit everybody. This is the definition which is known as the ‘polar case of a pure Samuelsonian public good’. A pure public good in this sense has two outstanding characteristics. The first is the supply characteristic known as ‘non-rivalry’ among consumers. It implies that at given costs of supply, an additional consumer does not affect the benefits of existing consumers (the good ‘can benefit everybody’). The second is the demand characteristic of ‘universal demand’. A good can qualify as a public good, only if it actually figures in everybody's utility function (the good ‘does benefit everybody’). This definition stands in opposition to the one of a pure private good: an economic good that can, and does, benefit only a single person.

In view of the important consequences of the distinction between public and private goods, it seems useful to review the concept of a Samuelsonian public good. It is also useful to consider some intermediate cases.

First, it must be emphasized that the concept of ‘public good’ as defined here has nothing to do with government. Public goods are provided privately and publicly. Conversely, governments are providing public and private goods. Of course, there are certain reasons why public goods, according to certain normative criteria, may be provided more efficiently in the public than in the private sector, but there are also circumstances under which the opposite will be the case.

Public Choice should be a tool for improved management of the government. Dr Kraan has taken a major step in this direction by applying it to the actual process of budgeting. The book is not only a step forward in theory, it should be a major step towards making Public Choice a practical aid to a number of officials and politicians.

Speaking for myself, one of the more important aspects of this book is that it indicates that a lot of theoretical work which was actually developed to a large extent by Americans looking at the open American government also applies to European governments, although there things are less open. This is no surprise to me. I had always thought this was true, but I am delighted to have evidence instead of having to depend on my instincts. Here, again, Kraan has made a major step forward and pointed the way to what we hope will be considerable additional research.

There are also fairly sizeable theoretical improvements here. Relying on his experience, Kraan argues that the bureaucracy, in those areas where the differences among politicians are not too great, plays a constructive role. It tends to clarify and bring together the positions of the politicians, with the result that the endless cycling which may be regarded as the inevitable consequence of the Arrow theorem does not occur. In those cases where the differences among politicians are sizeable, Kraan follows a hint from the ‘Calculus of Consent’, arguing that as long as all of the proposals are for increasing the budget it is possible for log-rolling to lead to a definite outcome.

Demand and supply in the public sector

Market economies are characterized by the public protection of private property rights. In such economies, goods can be alienated only on the basis of mutual agreement between proprietors. Usually such alienation involves exchange between suppliers and demanders, where suppliers are households that want to sell certain economic goods at a certain price and demanders are households that want to purchase certain economic goods at a certain price. The exchange decision is a contract that specifies quantities and sums of money to be transferred. The term ‘market mechanism’ is commonly used to denote the rule that relates the result of a contract or a set of contracts to the characteristics of demand and supply.

However, many households in market economies consist of more than a single individual. As far as the private sector is concerned, one can think of business corporations, families, foundations and associations. As far as the public sector is concerned, one can think of governments and incorporated public agencies. Since such a collective houshold can own property, it needs a mechanism of internal coordination in order to express its demand or supply in markets.

The term ‘budget mechanism’ is commonly used to denote the rule that relates the characteristics of demand or supply by a collective houshold to the preferences of its members. Note that the budget mechanism is not an alternative for the market mechanism, but rather a necessary complement to it for the case a household comprises more than a single individual.

The extended budgetary game

In chapter 4 bureaucratic supply behaviour was considered from the perspective of its effects upon the preferences of the individual politician. It seems reasonable to assume that if the political authority consists of a collective body, the bureaucrat will not only take into account the effects of strategic cost revelation upon individual preferences, but also the effects upon the outcomes of political decision-making. In other words, the bureaucrat will pay attention to interaction among politicians and she will make her strategy choices in view of her expectations. Furthermore, it may be assumed that as soon as decision-making involves more than a single service, not only does politico–bureaucratic interaction become a relevant aspect of the budgetary game, but also interaction among the bureaucrats themselves. That is to say, bureaucrats will take into account the supply behaviour of other bureaucrats in order to optimize their strategies.

The endogenization of bureaucratic strategies implies that bureaucrats enter as fully-fledged players into the budgetary game. In the resulting extended game, the bureaucrats are entirely different kinds of players than the politicians. This distinction concerns both the objectives which motivate each kind of player and the types of ‘moves’ each kind of player is allowed to make. The objectives and the moves have been discussed in chapters 3 and 4 respectively; it has been assumed that politicians seek the implementation of preferred policies, and that bureaucrats seek some optimal combination of Managerial Discretionary Profit (MDP) and output. Furthermore, the moves of politicians were assumed to consist of votes and those of bureaucrats of transformations of the Apparent Budgetary Cost Function (ABCF), in the sense discussed in chapter 4.

Perspectives on budgetary decision-making

The subject of this book is the analysis of the budgetary process in representative government from the perspective of public choice theory. Since there is a large literature on the budgetary process as well as on public choice theory, it seems appropriate to start with some clarification about the place of the present volume within both areas of scholarly activity.

The budgetary process in representative government is a theme which is being studied from different theoretical perspectives, public choice theory being only one of them. Looking at the postwar literature, four main perspectives can be distinguished.

The first is the normative perspective. This has been characteristic of the mainstream public finance literature, as exemplified, for instance, by the seminal handbook by R.A. Musgrave (1959). The central concern in this literature has been the application of welfare theoretical principles to the budgetary decisions of government. Major new developments in this literature originated in revisions of welfare theory itself. One can think, for instance, of the generalization of the conditions for optimal allocation of public goods, as initiated by Samuelson (1954), and the development of a new approach to social welfare functions (so-called ‘social choice theory’), as initiated by Arrow (1951).

Within the normative literature there is also a more practically oriented current, alongside the welfare theoretic branch. This is the area of financial management that gave rise to procedural innovations such as the Planning–Programming–Budget–System(PPBS), Management by Objectives (MBO) and Zero-Base-Budgeting (ZBB) in the USA, Programme Analysis and Review (PAR) and the Financial Management Initiative in the UK and the Reconsideration Procedure in the Netherlands.