THE ECONOMICS OF PROPERTY RIGHTS

THE ECONOMICS OF PROPERTY RIGHTS

International Studies in Economics and Econometrics VOLUME 22

The Economics of Property Rights: Towards a Theory of Comparative Systems by Svetozar Pejovich 77ie Center for Education and Research In Free Enterprise, Texas ASM University, College Station, Texas, U.S.A. If KLUWER ACADEMIC PUBLISHERS DORDRECHT / BOSTON / LONDON

Library of Congress Cataioging-in-Publication Data ISBN 0-7923-0878-6 Published by Kluwer Academic Publishers, P.O. Box 17,3300 AA Dordrecht, The Netherlands. Kluwer Academic Publishers incorporates the publishing programmes of D. Reidel, Martinus Nijhoff, Dr W. Junk and MTP Press. Sold and distributed in the U.S.A. and Canada by Kluwer Academic Publishers, 101 Philip Drive, Non^^ell, MA 02061, U.S.A. In all other countries, sold and distributed by Kluwer Academic Publishers Group, P.O. Box 322,3300 AH Dordrecht, The Netherlands. 02-0193-200 ts Printed on acid-free paper All Rights Reserved 1990 by Kluwer Academic Publishers No part of the material protected by this copyright notice may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system, without written permission from the copyright owner. Printed in the Netherlands

To my wife, Susan, and my children

TABLE OF CONTENTS Preface PART ONE 1 ECONOMIC SYSTEMS, INSTITUTIONS AND SCARCITY SCARCITY, INSTITUTIONS AND ECONOMIC BEHAVIOR The Sources of Institutional Change Endogenous Changes Exogenous Changes Suggested Readings 4 4 5 6 The Rise of Capitalism The Middle Ages The Great Transformation Philosophical Factors The Religious Reformation New Frontiers Sociological Factors Capital Formation Suggested Readings THE RISE OF SOCIALISM Capitalism and Catholic Philosophy Early (Pre-Marx) Socialists Sir Thomas More (1478-1535) French Socialists American Socialists Marxism Influences on Karl Marx Early French Socialists Classical German Philosophy Classical British Economics 7 9 9 10 10 11 12 12 15 15 16 16 17 17 18 18 18 19 19

The Economic Interpretation of History 20 The Process of Social Change 21 Suggested Readings 23 PART TWO THE PRIVATE-PROPERTY FREE-MARKET 25 ECONOMY 4 BASIC INSTITUTIONS OF CAPITALISM 27 Private Property Rights 27 The Meaning of the Right of Ownership 27 The Right of Ownership and Economic Behavior 28 New Institutional Economics (Property Rights Economics) 29 The Law of Contract 30 The Meaning of Contracts 30 The Law of Contract and Economic Behavior 30 Limited Government 31 The Government in a Capitalist Society 31 Limited Government and Economic Behavior 33 Suggested Readings 34 5 EXCHANGE IN A PRIVATE PROPERTY 35 CAPITALIST ECONOMY The Purpose of Exchange 36 The Terms and Extent of Exchange 37 Restrictions on Price Competition 38 Transaction Costs 38 Information 39 Negotiating Exchange 39 Enforcing Exchange 40 Attenuation of Private Property Rights 41 Nonpecuniary Income 41 Suggested Readings 43 6 PRODUCTION IN A PRIVATE PROPERTY 45 CAPITALIST ECONOMY Property Rights and Production Efficiency 45 The Role of Profit 47 Profit as an Allocator of Resources 48 Innovation as a Source of Profit 49 Monopoly as a Source of Profit 50

IX Predation 51 Collusion and Mergers 51 Legal Closures of the Market 51 Suggested Readings 52 7 THE RIGHT OF OWNERSHff AND THE FIRM 53 Methods of Organizing Production 53 The Unit of Economic Analysis 54 Economic Analysis of the Firm 55 The Conventional Capitalist Firm 55 The Modem Corporation 57 The Cost of Purchasing Nonpecuniary Goods 61 Size of the Opportunity Set 61 Suggested Readings 64 8 THE ATTENUATED RIGHT OF OWNERSHIP AND 65 THE FIRM The Regulated Firm 65 The Not-For-Profit Firm 65 The Codetermining Firm 66 Background of Codetermination 66 The History of Codetermination in Germany 67 Codetermination and Property Rights 69 Suggested Readings 71 9 THE ROLE OF FINANCIAL MARKETS IN A 73 PRIVATErPROPERTY, FREEnMARKET ECONOMY The Rate of Interest and Expectations 73 The Allocation of Consumable Goods Over Time 76 The Growth of Wealth 79 Property Rights and Innovation 80 Suggested Readings 82 PART THE SOVIET-TYPE ECONOMY 85 THREE 10 THE HISTORY AND DEVELOPMENT OF THE 87 SOVIET UNION THROUGH THE 1980S History of Russia Before 1917 88 The Kievan State 88

The Rise of Moscow 89 Russia Under the Romanovs 90 The Lenin Years 91 The Stalin Years 93 Post Stalin Years 94 Suggested Readings 95 11 BASIC INSTITUTIONS OF THE SOVIET-TYPE 97 ECONOMY: STATE OWNERSHIP State Ownership in Productive Assets 97 Sources of the Politburo's Power 98 The Choice of Output 98 The I>emand for a Religion 99 The Demand for Influence in the Third World 99 The Demand for Political Equality With the West 99 The Collectivization of Agriculture 99 The Limits of the Politburo's Power 99 State Ownership and Incentives to Innovate 102 Suggested Readings 103 12 BASIC INSTITUTIONS OF THE SOVIET-TYPE 105 ECONOMY: ECONOMIC PLANNING The Mechanism of Economic Planning 105 Supply Planning in the Soviet-Type Economy 106 Administrative Controls in the Soviet-Type Economy 107 Price Controls in the Soviet-Type Economy 108 Economic Planning and the Social Opportunity Set 109 Transaction Costs and an Expansion of the Social Opportunity Set 110 Transaction Costs and a Contraction of the Social Opportunity Set 112 Cheating and Lying 113 Suggested Readings 114 13 BASIC INSTITUTIONS OF THE SOVIET-TYPE 115 ECONOMY: THE POLITICAL AND ECONOMIC MONOPOLY OF THE POLITBURO The Contract Between the Politburo and the People 115 Political Structure in the USSR in the Late 1980s 116 Formal Political Structure 116 Informal Political Structure 117

The Soviet Bureaucracy 118 Suggested Readings 120 14 THE BEHAVIOR OF THE SOVIET-TYPE FIRM 121 The Manager's Incentives 121 The Manager's Survival Set of Choices 122 The Behavior of the Soviet-Type Firm and the Economy 125 Suggested Readings 127 15 PERFORMANCE OF THE SOVIET-TYPE 129 ECONOMY The Quality of Life in the Soviet-Type Economy 129 Education in the Soviet Union 130 Housing in the Soviet Union 130 Health Care in the Soviet Union 132 The Consumer in the Soviet Union 132 Incomes in the Soviet Union 135 Soviet Agriculture 135 The Quantitative Performance of the Soviet Economy 137 Suggested Readings 139 16 TOWARD THE END OF THE SOVIET-TYPE 141 ECONOMY The Nature of Reforms in the Soviet-Type Economy 141 The Gorbachev Reforms in the USSR 142 Economic Analysis of Perestroika 143 Perestroika and Business Firms 143 Perestroika and the Problems of Supplies 144 Perestroika and the Shortage of Supplies 144 Perestroika and the Shortage of Consumer Goods 145 Perestroika and the Nomenklatura 146 Suggested Readings 148 Appendix: Economic Developments in Hungary and 148 Poland Hungary 149 Summary of Developments in the Hungarian Economy, in 1988 149 Privatization in Hungary 151 Poland 159 Outline of Economic Program 159

Xll PART FOUR THE YUGOSLAV-TYPE ECONOMY 173 17 BASIC INSTITUTIONS OF THE LABOR-MANAGED 175 ECONOMY The Development of the Labor-Managed Economy in Yugoslavia 175 Nomenklatura and the Labor-Managed Economy 176 The Agency for Social Bookkeeping 177 Contractual Planning 177 Suggested Readings 180 18 THE BEHAVIOR OF THE LABOR-MANAGED 181 FIRM The Governance of the Labor-Managed Firm 181 The Total Revenue of the Yugoslav Firm 182 Economic Behavior of the Labor-Managed Firm 183 The Role of Bank Credit 187 The Allocation of Earnings and the State 189 Suggested Readings 189 19 FAILURE OF THE LABOR-MANAGED TYPE 191 ECONOMY A Property Rights Analysis of the Labor-Managed Firm 193 Transaction Costs and the Opportunity Set 193 The Choice of Organization 193 The Bureaucracy 193 The Location of Decision Making in the Labor- Managed Firm 194 Incentives and the Social-Opportunity Set 195 The Employment Problem 195 The Allocation of Risk 195 Investment Decisions 196 Incentives to Innovate 196 Suggested Readings 197 Appendix: Economic Reforms in Yugoslavia 197 Index of Names 201

PREFACE To understand recent developments in Eastern Europe requires a method of analysis that is capable of internalizing into a theoretical framework (i) the logical premises deduced from the costs of transactions and incentive structures generated by various institutions and (ii) the evidence for refutable implications of those premises. The economics of property rights is such a theory. It expands the scope of the ability of economic analysis to explain a wide range of institutional structures and provides empirical corroboration of its logical implications. The economics of property rights is, then, an effective scholarly instrument that offers more significant understanding of the three current issues in the area of comparative economic studies: (i) evaluating the performance of alternative institutional arrangements, (ii) explaining the failure of socialist institutions in Eastern Europe, and (iii) identifying the costs (political as well as economic) of institutional reforms in that part of the world. In that sense, the book is both timely and relevant. In the late 1980s East Europeans crossed the threshold of fear and forced their leaders to abandon Marxism. With that theory of history dead and buried, the cost of current sacrifices in the pursuit of socialism has risen relative to the present value of its expected future benefits. Since the rulers in Eastern Europe could not continue to hide their taste for political monopoly behind a facade of words about the inevitability of socialism, they have begun to raise the spectrum of either "humane" socialism or the coexistence of capitalist and socialist institutions. In the process, an institutional vacuum has been created in that part of the world. The book is timely because property rights analysis concentrates on detecting and evaluating differences in the costs of transactions and incentive structures among various (present and potential) institutions. Research in comparative economics has traditionally relied on neoclassical economic analysis. However, the basic premises from which the logical implications of neoclassical economic analysis are deduced limit that theory's applicability and any reliability to the private-property-type economy. First, neoclassical economic analysis ignores the costs of transactions which are not invariant with respect to the organizational structures. Second, neoclassical economic analysis ignores the incentive effects of alternative institutional arrangements. Thus, the emphasis on property rights analysis makes this book relevant for the study of comparative economic systems in a time when the most important issues are why, how, and at what price institutional reforms. For property rights analysis relates alternative institutions to economic outcome via their effects on the costs of transactions and incentive structures. In the process, it provides the logical premises for various institutions from which refutable implications can be deduced.

I am grateful to the Lynde and Harry Bradley Foundation for the financial support that made this book possible. Over a period of the last ten years, the Earhart Foundation and the Texas Educational Association have supported my research on the economics of socialism upon which parts of this book are based. Armen Alchian, Allan Meltzer, and Steve Wiggins read parts of this manuscript and provided many valuable comments and encouragements. Maureen Creamer and Susan Dederich-Pejovich provided valuable editorial and technical assistance. Susan Mills did an outstanding job in preparing the diagrams for the book. Judy Roessner did her usual perfect job in putting the manuscript together for publication. Finally, I want to thank the Board of Directors of the Center for Free Enterprise at Texas A&M University, in particular Herb Schiff, for their support and encouragement over quite a few years. Svetozar Pejovich College Station, Texas May, 1990