Lawlessness and Economics
Alternative Modes of GovernanceBy Avinash K. DixitPrinceton University Press
Copyright © 2004 Princeton University Press
All right reserved.
ISBN: 978-0-691-13034-7
Chapter One
Economics With and Without the Law 1.1 The Need for Economic Governance
Most economic activities and interactions share several properties that together create the need for an institutional infrastructure of governance. First, these activities and interactions are opportunities to create or add value. This includes creation of tangible or intangible property (such as improved land, physical and human capital, reputation, and goodwill) and exchange of goods and services. Second, the activities require input from several individuals. We have known since the birth of economics how division of labor enhances productivity; more recently, we have recognized the importance of creation and preservation of common property resources. Third, the interactions are based on explicit or implicit contracts voluntarily made by all the parties involved; exchanges of a good or service for another good or service or money are the main instances of this. Some actions may be unilaterally undertaken by one party but create costs or benefits for another; examples include accidental or deliberate damage to property, or its opposite, namely positive spillovers that improve another's property.
Everyone can potentially benefit from the creation or addition of economic value. However, each participant in the process usually has available to him various actions that increase his own gain, while lowering the others' gain by a greater amount. The only exceptions are situations involving simultaneous exchange of goods or services of immediately verifiable attributes and qualities, but these are a small subset of all economic interactions. In most situations, the participants have opportunities to supply defective goods, shirk on the job, renege on payment, and so on. Williamson (1979, 1985) has coined the term "opportunism" for this whole class of actions that tempt individuals but hurt the group as a whole.
Problems also arise with property rights. If no mechanisms-governmental or non-governmental-exist to deter theft, then any one person can wait for someone else to create property or produce output and then steal it; this usually takes less effort than creating the property or the product oneself. Some may even extort money from others by making threats of destroying their property. Hirshleifer (2001), Grossman and Kim (1985), and others have focused on these problems.
Anticipation of opportunism, theft, or extortion constitutes a strong disincentive to making potentially valuable investments or entering into mutually beneficial contracts in the first place. Therefore if market economies are to succeed, they need a foundation of mechanisms to deter such privately profitable but socially dysfunctional behaviors, and thereby to sustain adequate incentives to invest, produce, and exchange. In other words, markets need the underpinning of institutions of economic governance.
1.2 Economics Taking the Law for Granted
Economists have always recognized the need for governance. However, until relatively recently they assumed that the government, specifically the institution and machinery of the state's law, provided the needed governance. Criminal law, while it has major non-economic functions, also serves to deter theft and some forms of economic fraud. Civil law has economic aspects centrally in its concerns. Contract law can be said to be mainly for the governance of economic activity; laws of tort and liability pertain to contracts as well as non-contractual relationships, both mainly in the economic sphere.
Even the most libertarian economists, who deny the government any useful role in most aspects of the economy, allow that making and enforcing laws that give clear definitions of property rights, and ensuring adherence to voluntary private contracts, are legitimate and indeed essential functions of government, in addition to national defense. Friedman (1962, p. 2) puts this succinctly:
[The government's] major functions must be to protect our freedom both from the enemies outside our gates and from our fellow-citizens: to preserve law and order, to enforce private contracts, to foster competitive markets.
There seems universal agreement in traditional economics that the framework of law is a necessary condition for a market economy to succeed.
Extreme libertarians regard the government's legal framework as not only necessary but also sufficient for markets to function well-the Coase Theorem (Coase 1960, 1988) says that if property rights are well defined, voluntary contracts can achieve all available economic benefits, including the internalization of externalities and the provision of public goods. Most other economists recognize the possibility of market failure even under the aegis of a well-functioning state law; for them, institutions of law are not a sufficient condition to ensure optimal outcomes from markets. For example, McMillan (2002, pp. ix, x) lists three other elements for markets to work well: "information flows smoothly, ..., side-effects on third parties are curtailed, and competition is fostered." The opposites of these, namely imperfect information, externalities, and imperfect competition, are well-recognized causes of market failure, and they can exist regardless of whether a government adequately protects property rights and enforces contracts.
Thus conventional economic theory does not underestimate the importance of law; rather, the problem is that it takes the existence of a well-functioning institution of state law for granted. It assumes that the state has a monopoly over the use of coercion, and that the state designs and enforces laws with the objective of maximizing social welfare. Moreover, until the last 30 years or so, that is, until economics recognized the ubiquity and importance of information asymmetries and transaction costs, the usual implicit assumption was that the law operated costlessly.
This simple view of the law made it possible to achieve faster progress in the research on the economic forces of supply and demand, and of their equilibration in markets; therefore it was a useful abstraction in its time. However, its shortcomings soon hinder rather than help the economic analysis of markets and limit its usefulness. Only advanced countries in recent times come anywhere near the economist's ideal picture, in which the government supplies legal institutions that are guided solely by concern for social welfare and operate at low cost. In all countries through much of their history, the apparatus of state law was very costly, slow, unreliable, biased, corrupt, weak, or simply absent. In most countries this situation still prevails. Markets with such weak underpinnings of law differ greatly from those depicted in conventional economic theory.
Deficiencies of the law are most acute in less-developed countries (LDCs) and in transition economies. For example, Bearak (2000) reports that there are 25 million cases pending before the courts in India, and even if no new ones are filed, it will take 324 years to clear the backlog. Murrell (1996, p. 34) found that laws in many transition economies were "a facade without a foundation." Recent assessments of the effectiveness of the legal system in post-Soviet Russia differ among Western observers, but a fair assessment is that while the Arbitrazh court system created to handle commercial disputes has begun to function reasonably well in handing down verdicts, getting these verdicts enforced remains highly problematic, especially for smaller enterprises (Hendley and Murrell 2001; Hay and Shleifer 1998). McMillan and Woodruff (1999, 2000) and others have found similar situations in other transition economies in Eastern Europe and in Vietnam. Djankov and Murrell (2002) survey this literature.
Of course economic activity does not grind to a halt because the government cannot or does not provide an adequate underpinning of law. Too much potential value would go unrealized; therefore groups and societies have much to gain if they can create alternative institutions to provide the necessary economic governance. They attempt to develop, and sometimes succeed in developing, such institutions of varying degrees of effectiveness. These include self-protection or hired professional protection for property rights (see, for example, Hirshleifer 2001; Gambetta 1993), networks of information transmission, and social norms and punishments for contract enforcement (see, for example, Greif 1993, 1994; Milgrom, North, and Weingast 1990; Gambetta 1993). Indeed, an extreme version of the Coase Theorem says that everything works out in the best feasible way (Stigler 1988). If governance is costly, the least-cost method will get chosen from among the available institutions, whether it be state law or a private alternative. In this view, the emergence of a state or government is itself endogenous, and will occur if, and only if, it is the most efficient mode of governance. But even without going that far, we can recognize that societies will attempt to evolve other institutions, albeit imperfect ones, to underpin their economic activity when state law is missing or unusable. In other words, governmental provision of legal institutions is not strictly necessary for achieving reasonably good outcomes from markets.
Rodrik (2003, pp. 10-16) summarizes the lessons of case studies of several countries as follows.
Institutions that provide dependable property rights, manage conflict, maintain law and order, and align economic incentives with social costs and benefits are the foundation of long-term growth.... State institutions are not the only ones that matter. Social arrangements can have equally important and lasting consequences.... Modest changes in institutional arrangements ... can produce large growth payoffs ... [but] the required changes can be highly specific to the context.
This yields some general lessons for policy-makers in LDCs and transition economies who are contemplating market-oriented reforms and privatizations, and for their economic advisers from Western countries and international organizations. They must recognize that markets will not succeed unless they are supported by adequate governance institutions. The processes of creating the institutions and the apparatus of state law, and of improving them to the point where they function well, are slow and costly. But it is not always necessary to create replicas of Western-style state legal institutions from scratch; it may be possible to work with such alternative institutions as are available, and build on them. Of course, to do this we must have a good understanding of how various institutions of governance work, and of how they interact with each other and with an imperfect state law where that exists. My aim in this book is to contribute to the improvement of this understanding.
1.3 "Lawlessness and Economics" in Context
Where does the study of alternative institutions for protection of property rights and enforcement of contracts, to which I have given the eye-catching albeit strictly inaccurate title "Lawlessness and Economics," stand in relation to many closely related fields of inquiry? Such demarcation of fields or subfields is always a difficult question. Reality is usually a complex mixture, whereas theoretical analysis usually proceeds faster and goes deeper by identifying pure conceptual categories. In the present context, all countries have governments of some kind, of varying scope, competence, and benevolence. And in all of them, significant aspects or components of economic activity are conducted without direct reference or recourse to the state's law. Isolating pure categories from this reality is a matter of judgment, and any attempt at a precise definition or delineation leaves significant exceptions or overlaps. But an attempt must be made, however imperfect, so that researchers and students in neighboring areas can fit this book into the context of their own work.
Lawlessness and Economics can be regarded as a subfield within the broad conceptual framework of the New Institutional Economics. This large and varied body of research has built upon pioneering ideas of Coase (1937, 1960, 1988), North (1990), Williamson (1985, 1996), and others; Williamson (2000) has given us a good recent overview and assessment.
North distinguishes between institutions and organizations. For him, institutions are the overarching framework of rules and constraints, formal and informal, that govern interactions among individuals; constitutions and social norms are examples. Organizations are groups of individuals that operate within the general framework of institutions, and implement the rules and norms of the institutions; examples are legislatures, political parties, and universities. Of course there are interactions and feedbacks between institutions and organizations. The rules and constraints imposed by institutions do not eliminate all freedom for organizations to act, and since organizations have members with differing interests and abilities, interesting issues of "the play of the game" at this level must be analyzed. Institutions can then evolve to alter the rules of the game so as to achieve better outcomes from the play at the organizational level. Finally, individuals interact within the frameworks set up by both institutions and organizations, and these transactions have their costs of information, commitment, and so on. North (1990, pp. 92-104) argues that institutions and organizations attempt to economize on transaction costs, but usually fall short of optimality, especially when changing economic and technological conditions require changed or new institutions. He gives two categories of reasons for the long lags and bottlenecks in the process of institutional change: first, resistance by powerful special interests with stakes in the old system; and second, multiple equilibria and historical accidents.
Others use the same terms in slightly different senses and drawsomewhat different distinctions. For example, in his pioneering game-theoretic analysis, Schotter (1981, p. 11) defines institutions as
a regularity in social behavior that is agreed to by all members of society, specifies behavior in specific recurrent situations, and is either self-policed or policed by some external authority.
Thus his institutions specify the strategies that the individuals should choose. That is, they include aspects of the play of the game as well as the rules. Calvert (1995a,b) develops this idea further, and interprets it more explicitly as specifying the equilibrium that is to be played. Sobel (2002, p. 147) similarly says that
an individual's expectation of the response to his action is often an important part of the institutional environment; that is, the institutional environment also serves to coordinate beliefs and select equilibria.
And Greif (2000) defines institutions as
a system of social factors-such as rules, beliefs, norms, and organizations-that guide, enable, and constrain the actions of individuals.
Thus he includes organizations as an example of institutions, not a separate category. Moreover, the beliefs in his analysis are beliefs about the strategies that otherswould choose in off-equilibrium situations, and therefore serve to select an equilibrium; this accords with Calvert's view of institutions. I conclude that North's conceptual distinction between the rules and the play of the game, leading to the distinction between institutions and organizations, serves a useful purpose of focusing our attention on the different functions, but there are many feedbacks between the two categories blurring the distinction.
Williamson (2000) draws finer distinctions with a four-level classification scheme. At the first (highest or most basic) level stand informal institutions, such as religion, social customs and norms. These are slow to change, over the timescale of centuries or millennia. At the second level is the institutional environment, consisting of formal rules, such as constitutions and laws. The timescale of evolution of these is measured in decades. The play of the game occurs at the third level, and this includes the choice of appropriate modes of governance for each type of transaction, or organizations in North's sense, the aim being to economize on transaction costs. The idea that transactions and governance modes are aligned in this way is Williamson's (1996, p. 12) famous discriminating alignment hypothesis. Finally, the fourth and lowest level contains routine economic activities such as production, employment, market equilibration.
Williamson places other subfields within this scheme. Positive Political Theory (PPT) operates mostly at the second level, focusing on political institutions such as the executive and the legislature, and their implications for economic performance. Transaction Cost Economics (TCE) is located mostly at the third level. It focuses on economic structures such as firms and on transactions within and across these structures. It studies how the economic structures and transactions respond to the available governance structures and their limitations.
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