S. Pejovich_The Economics of Property Rights

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THE ECONOMICS OF PROPERTY RIGHTS


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International Studiesin Economics and EconometricsVOLUME 22


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The Economics ofProperty Rights:Towards a Theory ofComparative SystemsbySvetozar Pejovich77ie Center for Education and Research In Free Enterprise,Texas ASM University, College Station,Texas, U.S.A.

IfKLUWER AC AD EM IC PUB LISHERSDORDRECHT / BOSTON / LONDON


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Library of Congress Cataioging-in-Publication Data

ISBN 0-7923-0878-6

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To my wife, Susan, and my children


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TABLE OF CONTENTS

PrefacePART ONE

1

ECONOMIC SYSTEMS, INSTITUTIONS ANDSCARCITYSCARCITY, INSTITUTIONS AND ECONOMICBEHAVIORThe Sources of Institutional ChangeEndogenous ChangesExogenous ChangesSuggested ReadingsThe Rise of CapitalismThe Middle AgesThe Great TransformationPhilosophical FactorsThe Religious ReformationNew FrontiersSociological FactorsCapital FormationSuggested ReadingsTHE RISE OF SOCIALISMCapitalism and Catholic PhilosophyEarly (Pre-Marx) SocialistsSir Thomas More (1478-1535)French SocialistsAmerican SocialistsMarxismInfluences on Karl Marx

Early French SocialistsClassical German PhilosophyClassical British Economics

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79910101112121515161617171818181919


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The Economic Interpretation of History 20The Process of Social Change 21Suggested Readings 23PART TWO THE PRIVATE-PROPERTY FREE-MARKET 25ECONOMY

4 BASIC INSTITUTIONS OF CAPITALISM 27Private Property Rights 27The Meaning of the Right of Ownership 27

The Right of Ownership and Economic Behavior 28New Institutional Economics (Property RightsEconomics) 29The Law of Contract 30The Meaning of Contracts 30The Law of Contract and Economic Behavior 30Limited Government 31The Government in a Capitalist Society 31Limited Government and Economic Behavior 33Suggested Readings 345 EXCHANGE IN A PRIVATE PROPERTY 35CAPITALIST ECONOMY

The Purpose of Exchange 36The Terms and Extent of Exchange 37Restrictions on Price Competition 38Transaction Costs 38Information 39Negotiating Exchange 39Enforcing Exchange 40Attenuation of Private Property Rights 41Nonpecuniary Income 41Suggested Readings 43

6 PRODUCTION IN A PRIVATE PROPERTY 45CAPITALIST ECONOMYProperty Rights and Production Efficiency 45The Role of Profit 47Profit as an Allocator of Resources 48Innovation as a Source of Profit 49Monopoly as a Source of Profit 50


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IX

Predation 51Collusion and Mergers 51Legal Closures of the Market 51Suggested Readings 52

7 THE RIGHT OF OW NERSHff AND THE FIRM 53Methods of Organizing Production 53The Unit of Economic Analysis 54Economic Analysis of the Firm 55The Conventional Capitalist Firm 55

The Modem Corporation 57The Cost of Purchasing Nonpecuniary Goods 61Size of the Opportunity Set 61Suggested Readings 648 THE ATTENUATED RIGHT OF OWNERSHIP AND 65THE FIRM

The Regulated Firm 65The Not-For-Profit Firm 65The Codetermining Firm 66Background of Codetermination 66The History of Codetermination in Germany 67Codetermination and Property Rights 69Suggested Readings 719 THE ROLE OF FINANCIAL MARKETS IN A 73PRIVATErPROPERTY, FREEnMARKET ECONOMY

The Rate of Interest and Expectations 73The Allocation of Consumable Goods Over Time 76The Growth of Wealth 79Property Rights and Innovation 80Suggested Readings 82PART THE SOVIET-TYPE ECONOMY 85THREE

10 THE HISTORY AND DEVELOPMENT OF THE 87SOVIET UNION THROUGH THE 1980SHistory of Russia Before 1917 88The Kievan State 88


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The Rise of Moscow 89Russia Under the Romanovs 90The Lenin Years 91The Stalin Years 93Post Stalin Years 94Suggested Readings 95

11 BASIC INSTITUTIONS OF THE SOVIET-TYPE 97ECONOMY: STATE OWNERSHIPState Ownership in Productive Assets 97Sources of the Politburo's Power 98The Choice of Output 98The I>emand for a Religion 99The Demand for Influence in the Third World 99The Demand for Political Equality With the West 99The Collectivization of Agriculture 99The Limits of the Politburo's Power 99State Ownership and Incentives to Innovate 102Suggested Readings 103

12 BASIC INSTITUTIONS O F THE SOVIET-TYPE 105ECONOMY: ECONOMIC PLANNINGThe Mechanism of Economic Planning 105Supply Planning in the Soviet-Type Economy 106Administrative Controls in the Soviet-Type Economy 107Price Controls in the Soviet-Type Economy 108Economic Planning and the Social Opportunity Set 109Transaction Costs and an Expansion of the Social

Opportunity Set 110Transaction Costs and a Contraction of the SocialOpportunity Set 112Cheating and Lying 113Suggested Readings 11413 BASIC INSTITUTIONS OF THE SOVIET-TYPE 115ECONOMY: THE POLITICAL AND ECONOMICMONOPOLY OF THE POLITBURO

The Contract Between the Politburo and the People 115Political Structure in the USSR in the Late 1980s 116Form al Political Structure 116Informal Political Structure 117


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The Soviet Bureaucracy 118Suggested Readings 120

14 THE BEHAVIOR OF THE SOVIET-TYPE FIRM 121The M anager's Incentives 121The M anager's Survival Set of Choices 122The Behavior of the Soviet-Type Firm and the Economy 125Suggested Readings 12715 PERFORMANCE O F THE SOVIET-TYPE 129ECONOMYThe Quality of Life in the Soviet-Type Economy 129Education in the Soviet Union 130Housing in the Soviet Union 130Health Care in the Soviet Union 132The Consumer in the Soviet Union 132Incomes in the Soviet Union 135Soviet Agriculture 135The Quantitative Performance of the Soviet Economy 137Suggested Readings 139

16 TOWARD THE END OF THE SOVIET-TYPE 141ECONOMYThe Nature of Reforms in the Soviet-Type Economy 141The Gorbachev Reforms in the USSR 142Economic Analysis of Perestroika 143Perestroika and Business Firm s 143

Perestroika and the Problems of Supplies 144Perestroika and the Shortage of Supplies 144Perestroika and the Shortage of Consumer Goods 145Perestroika and the Nom enklatura 146Suggested Readings 148Appendix: Economic Developments in Hungary and 148PolandHungary 149Summary of Developments in the HungarianEconomy, in 1988 149Privatization in Hungary 151Poland 159Outline of Economic Program 159


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X l l

PART FOUR THE YUGOSLAV-TYPE ECONOMY 17317 BASIC INSTITUTIONS OF THE LABOR-MANAGED 175ECONOMY

The Development of the Labor-Managed Economy inYugoslavia 175Nomenklatura and the Labor-Managed Economy 176The Agency for Social Bookkeeping 177Contractual Planning 177Suggested Readings 18018 THE BEHAVIOR OF THE LABOR-MANAGED 181FIRM

The Governance of the Labor-Managed Firm 181The Total Revenue of the Yugoslav Firm 182Economic Behavior of the Labor-Managed Firm 183The Role of Bank Credit 187The Allocation of Earnings and the State 189Suggested Readings 18919 FAILURE OF THE LABOR-MANAGED TYPE 191ECONOMY

A Property Rights Analysis of the Labor-Managed Firm 193Transaction Costs and the Opportunity Set 193The Choice of Organization 193The Bureaucracy 193The Location of Decision Making in the Labor-Managed Firm 194Incentives and the Social-Opportunity Set 195The Employment Problem 195The Allocation of Risk 195Investment Decisions 196Incentives to Innovate 196Suggested Readings 197Appendix: Economic Reforms in Yugoslavia 197

Index of Names 201


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PREFACE

To understand recent developments in Eastern Europe requires a method of analysis thatis capable of internalizing into a theoretical framework (i) the logical prem ises deducedfrom the costs of transactions and incentive structures generated by various institutionsand (ii) the evidence for refutable implications of those premises. The economics ofproperty rights is such a theory. It expands the scope of the ability of economic analysisto explain a w ide range of institutional structures and provides empirical corroborationof its logical implications. The economics of property righ ts is, then, an effectivescholarly instrument that offers more significant understanding of the three current issuesin the area of comparative economic studies: (i) evaluating the performance ofalternative institutional arrangements, (ii) explaining the failure of socialist institutionsin Eastern Europe, and (iii) identifying the costs (political as well as economic) ofinstitutional reforms in that part of the world. In that sense, the book is both timely andrelevant.In the late 1980s East Europeans crossed the threshold of fear and forced theirleaders to abandon M arxism. With that theory of history dead and buried, the cost ofcurrent sacrifices in the pursuit of socialism has risen relative to the present value of itsexpected future benefits. Since the rulers in Eastern Europe could not continue to hidetheir taste for political monopoly behind a facade of words about the inevitability ofsocialism, they have begun to raise the spectrum of either "humane" socialism or thecoexistence of capitalist and socialist institutions. In the process, an institutional vacuumhas been created in that part of the world. The book is timely because property rightsanalysis concentrates on detecting and evaluating differences in the costs of transactionsand incentive structures among various (present and potential) institutions.Research in comparative econom ics has traditionally relied on neoclassical economicanalysis. How ever, the basic premises from which the logical implications ofneoclassical economic analysis are deduced limit that theory's applicability and anyreliability to the private-property-type economy. First, neoclassical economic analysisignores the costs of transactions which are not invariant with respect to the organizational structures. Second, neoclassical economic analysis ignores the incentive effects ofalternative institutional arrangements. Thus, the emphasis on property righ ts analysismakes this book relevant for the study of comparative econom ic systems in a time whenthe most important issues are why, how, and at what price institutional reforms. Forproperty rights analysis relates alternative institutions to economic outcome via theireffects on the costs of transactions and incentive structures. In the process, it providesthe logical premises for various institutions from which refutable implications can bededuced.


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I am grateful to the Lynde and Harry Bradley Foundation for the financial supportthat made this book possib le. Over a period of the last ten years, the EarhartFoundation and the Texas Educational Association have supported my research on theecon om ics of socialism upon which parts of this book are based. Armen Alchian, A llanMeltzer, and Steve Wiggins read parts of this manuscript and provided many valuablecomm ents and encouragements. Maureen Creamer and Susan Dederich-Pejovichprovided valua ble editorial and technical assistance . Susan Mills did an outstanding jobin preparing the diagrams for the book. Judy Roessner did her usual perfect job inputting the manuscript together for publication. Finally, I want to thank the Board ofDirectors of theCenter for Free Enterprise at Texas A &M Un iversity, in particular HerbSchiff, for their support and encouragement over quite a few years.

Svetozar PejovichCollege Station, TexasMay, 1990


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PART ONEECONOMIC SYSTEMS, INSTITUTIONS

AND SCARCITY


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CHAPTER 1SCARCITY, INSTITUTIONS AND ECONOMIC BEHAVIOR

No m atter how affluent or poor w e are as individuals or as a nation, scarcity is alwayspresent; that is, what we want exceeds what is available. Nature can be blamed for thisstate of affairs because it has given us fewer resources than we believe we must have.And other people can be considered culprits because they compete with us for scarcegoods. Thus, we all live in a world of scarcity. To get a little bit more of something,a little bit of something else has to be given up.In addition to being scarce, resources have alternative uses. This means that, inorder to survive, all human societies must face and resolve two fundamental issues: whogets what and who does what. The former concerns the distribution of goods that havealready been produced. The latter concerns production. Those issues are two sides ofthe same coin. How ever, it is useful, for the purpose of analysis, to look at these issuesseparately. Each time an individual gets a bit of something, that much less is left forothers. And every time we assign a resource to produce something, we are giving upa bundle of other things the same resource could have produced.Scarcity forces all of us to make choices among limited alternatives. Given theinherent instinct for survival, a person makes choices that are purposeful, although notalways successful. Human history has been about our search for more utility (which isnot necessarily the same thing as more goods). Moreover, w e have been consistent inresponding to the circumstances that determine the costs of various alternatives. Despitestrong pressures from theologians and many philosophers to give up the natural desirefor more , human wants are demonstrably boundless. As soon as we get more ofsomething, we want still more of it and of other things. This is a positive statement thatis consistent with historical evidence and implies no moral judgment.The central problem of economics is then one of making choices with respect to theallocation and use of resources. Socioeconomic problems in all societies have the sameorigin: scarcity. How ever, solutions to these problems differ from one country toanother because the structures of institutions vary across the globe.As social groups developed, it became clear that social activity involves humaninteractions at two levels. The first level of social activity is the development, modification and specification of institutions. The second level of social activity is socialinteraction w ithin the prevailing institutional struc ture. The former is about the rulesof the gam e, while the latter is about the game itself. And the rules have a great impacton how the game is played. Different institutional arrangements have their ownincentive structures, and those incentives have specific and predictable effects on humanbehavior. Human behavior, in turn, affects both the allocation of resources and the flow


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of innovation. It follows that economic analysis can provide refutable propositions aboutthe effects of alternative institutional arrangements on the economy. The importance ofinstitutions for the study of different economic systems is thus quite clear.Institutions develop to govern the interactions among men with respect to problemsthat have their source in scarcity. Initially, institutions were based on customs whichincluded past experiences, taboos, standards of behavior, and perceptions that individualshad formed about the world around them. In time, religious and other ideologies cameto have considerable influence on customs. With the rise of modem states, laws andregulations replaced most customs. The development of institutions can then be deducedfrom the fact of scarcity and human survival instincts. Institutions are defined as thelegal, administrative and customary arrangements for repeated human interactions.

The Sources of Institutional Change

Our improved understanding of how alternative institutions affect the allocation ofresources and the flow of innovation is a major contribution of the new institutionaltheory known as property righ ts economics. Since changes in institutions must affectthe economy's performance, it is important to determine what causes institutions tochange, and what determines the direction of change. Historical evidence shows thatinstitutional changes have been both endogenous and exogenous to the system.ENDOGENOUS CHANGESThe relationship between the rules of the game and the game itself is reciprocal. Rulesaffect the game in specific and predictable ways and are, in turn, adjusted and modifiedin response to the development of new opportunities for human interactions. Supposethere is an event that creates opportunities for individuals or groups not deemedprofitable before. Such an event could be the opening of new markets, technicalprogress, or changes in relative prices. Whatever the event, it changes the cost-benefitratio associated with various social activities and provides incentives for individuals andgroups to seek and negotiate new contractual agreements. Professor H. Demsetz hasexplained the creation of property rights among Indian tribes in North America asfollows:

Before the fur trade became established, hunting was carried on primarily forthe purposes of food and the relatively few furs that were required for thehunter's family... Hunting could be practiced freely and was carried on withoutassessing its impact on other hunters. But these external effects were of suchsmall significance that it did not pay for anyone to take them into account.There did not exist anything resembling private ownership of land....The advent of the fur trade had two imm ediate consequences. First, thevalue of furs to the Indians was increased considerably. Second, and as a


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result, the scale of hunting activity rose sharply. Both conseque nces must haveincreased considerably the benefits associated with free hunting. Th e propertyrights system began to change, and it required to take account of the eco nom iceffects m ade important by the fur trade. Th e geograph ical or distributionalevidence...indicates an unmistakable correlation between early centers of furtrade and the oldest and most complete development of the private huntingterritory. (H. Dem setz, "Toward a Theory of Property Rights," Am ericanEconomic Journal. 57, 1967, p. 352)If the prevailing institutional structures are poorly attuned to circumstances and fail toembrace such contracts, utility-seeking individuals will generate spontaneous pressureto modify the rules of the gam e in order to embrace the novelty. These gradual,evolutionary changes in the prevailing institutional arrangements are adjustments in therules of the game made in order to adapt the system to changes in the set of socialcho ices. For exam ple, the resumption of population growth in fourteenth-centuryEurope brought about an increase in the value of land relative to labor. The benefitsfrom the right of ow nership in land rose relative to its cos t. Slo w ly, pressures mountedfor the right of ownership in land to replace the feudal property-rights structures. Inmodem times, the expansion of markets and technological developments made massproduction of good s relatively cheap and profitable. H ow ev er , individual entrepreneursand business firms had to raise large amounts of capital in order to exploit newopportunities and the owner's unlimited liability for debts created a serious problem.Unlimited liability threatened the exploitation of new opportunities because it madecontractual agreements for bringing in privately ow ned resources too costly. A newconcept eventually emerged: limited liability. Under this rule each owne r's liabilitywould be limited to the value of his investment in the enterprise. M oreover, it shiftedthe risk to financial institutions, which have a comparative advantage in judging andevaluating investment opportunities. This modification in the rules of the gam eenhanced the rise of the modem corporation.

EXOGENOUS CHANGESInstitutional changes are also influenced by ideologies, various pressure groups, andbureaucratic judgm ents about what is best for the public. Instead of adapting the rulesof the game to the changing requirements of the game, exogenous changes adapt thegam e to the rules preferred by a specific interest group . For exam ple, codeterminationis a major social experiment in W estem Europe (more w ill be said about codeterminationlater in this bo ok ). Under this system labor representatives participate in the management of business firms. Labor leaders, bureaucrats, and some intellectuals in WesternEurope argue that codetermination bestows benefits on labor without any detrimentaleffects on shareholders. But, if codetermination is beneficial to both shareholders andlabor, why must shareholders be forced by law to accept it? W hy do they notvoluntarily negotiate this institutional restructuring? There is no law in Europe thatprohibits the imposition of codetermination. Th e fact that shareholders must be forced


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by law to accept codetermination is the best evidence that they a re adversely affected byit. Also, the rise of socialism in the East has been clearly brought about by Marxistideology, imposed by force, and maintained through terror.The second question is: What determines the direction of institutional change?Why have different countries evolved in radically different directions and at radicallydifferent rates? This is a complex issue, the discussion of which runs like a threadthroughout this book.In conclusion, social institutions change in response to forces that are eitherendogenous or exogenous. The former are changes to the rules of the game that enableindividuals to negotiate more effectively the contractual agreem ents that new economic

and social developments have made available. The latter are changes in the rules of thegame that are imposed upon the community from without by a "white knight."

SUGGESTED READINGS

Dem setz, H. "Toward a Theory of Property Rights," American Economic Journal. 57,1967.North, D. "Institutions, Economic Growth and Freedom," in Freedom . Democracy andEconomic Welfare (M. Walker, ed.), Vancouver: The Eraser Institute, 1988.S. Pejovich, "Toward an Economic Theory of the Creation and Specification of PropertyRights," Review of Social Economy. 30, 1972.


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CHAPTER 2THE R ISE OF CAPITALISM

In order to compare economic systems we must have some basic understanding of theirorigins. Do we owe the discovery of alternative institutions to an ingenious humanmind? Are capitalism and socialism "predictable" outcomes of the laws of history or"unintended" consequences of the gradual evolution of human knowledge andtechnology? This chapter will discuss the factors that contributed to the rise ofcapitalism.There is a great deal of literature and some disagreement about the genesis ofcapitalism. It seems best to consider that each and every major factor mentioned in thevoluminous literature played some contributing ro le in the rise of capitalism. Theconventional interpretation of the history of Western Europe is that economic andcultural development was interrupted by the fall of the Roman Em pire. Then the MiddleAges began and stretched onward nearly a thousand years, from the sixth century to theend of the fifteenth or beginning of the sixteenth. Economic development picked up inthe eleventh century but was again interrupted by the Black Death in the fourteenthcentury.

The Middle AgesThe collapse of the Roman Empire eliminated both Roman law, which was based onprivate ownership and contracts, and the machinery that enforced it. Initially, barbariccustoms and violence replaced Roman law as the means of resolving conflicts of interestamong competing individuals and groups. How ever, the high cost of negotiating,policing, and enforcing one's rights to life and property in post-Roman Europe led tothe gradual development of a socioeconomic system that is referred to as the feudalsystem.A survival strategy for a weaker man was to turn to a stronger man and give himthe nontransferable right of ownership in his land in exchange for protection and aninalienable right of tenancythe right to hold the land of the lord. The lord-vassalrelationship slowly evolved into a basic social institution in medieval Europe. The landheld by the vassal was called the feud. A lord could and often did become the vassalof still another m an; that is, he became both the lord of a weaker man and the vassal ofa stronger man. Eventually, a socioeconomic system developed based on a hierarchy


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of individuals holding property rights. The king was at the top of this long chain of"contractual" relationships, and the actual tillers of the land (serfs) were at the bottom.As the Middle Ages progressed the Catholic Church became an increasinglypow erful institution. It acquired a substantial mon opoly in the field of education.Libraries were located in monasteries and cathedrals, and the vast majority of literatepeop le were m onks. The Church thus became the repository of accumulated know ledge.Conseq uently, it acquired the pow er to interpret know ledge, to determine its uses, andto influence the direction of its grow th. The Ca tholic Church also w as m onopolistic inreligion, since it had no opposition in matters of faith.Predictab ly, the Church played a major role in the developm ent o f institutions in theM iddle Ag es. The church provided the philosophical rationale, the m oral justification,and, most importantly, the religious sanction for the socioeconomic system based on ahierarchical m ethod of holding property rights in land. The moral basis for politicalauthority and socioecon om ic privileges of medieval nobility wa s divine right. Kings andlords believed that they governed by the grace of God rather than with the consent oftheir subjects. Th is meant that secular rulers in the M iddle A ge s needed to have theChurcha worldly institution acting as "God's intermediary"on their side.The power of the Church explains two important features of community life in theM iddle Ag es: (i) a strong marriage between theology and philosophy , and (ii) an equally strong marriage between ethics and econ om ics. The law s, custom s, and socialinstitutions of the Middle A ges were determined largely by the teaching o f theologians.All aspects of social life were prejudged, controlled, and monitored by the CatholicChurch. Religiou s life and everyday social life were indistinguishable in the MiddleAges.By the end of the ninth century, this synthesis of religion and secular life took theform of a feudal society with a distinct and sharply defined clas s structure. The mobilitybetween social classes w as very lo w , almost nonexistent. A child bom to a peasant wasto remain a peasant for the rest of his life. A child bo m to a nobleman became amember o f the nobility. Every m an was considered equal in his class and entitled to themeans of subsistence suited to his station in life.

Philosophy and science were guided by the call to explain or justify theologicaltradition. Th e role of philosophy wa s to explain and support theological con clusions.Any conflict between the two was considered to be caused by som e philosophical error.Thu s, philosophy in the Middle A ges w as largely a handmaiden to theology. Similarly,econ om ic activities in the Middle A ges were regulated by ethical criteria. The legitimacy of eggiDomic activities was tested by reference to the moral teachings of theChurch, not to utility. The medieval Church was thus the final authority in morality,social life, and economic activities.The attitude of early church fathers toward trade and investm ent reflected the moralteachings o f the Church. The Church recognized the necessity o f trade but warned thatsuch economic activity stimulated the acquisitive spirit, which was perilous to the soul.It is then not surprising that trade was dominated by Jews, who lived outside theChristian orbit.


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The spirit of acquisition, usury, and the accumulation of wealth were condemnedby the Church. The high-water mark of the attack on the spirit of acquisition wasreached in the thirteenth century. Thom as Aquinas and his follow ers, called theSchoolmen, set down explicit rules regarding economic activities in general and theconcept of "just" price in particular. Accord ing to the Sch oolm en, the just price of anygood was to be equal to its cost of production plus a margin required to sustain theseller 's customary standard of l ivin g, and no more than that. It should be noted that themedieval church was also worried that production and exchange could destabilize thefeudal order. Th us, its objections to the spirit of acq uisition and accum ulation w ere notpurely religiou s. M oney was considered a nonproductive medium of excha nge, and itwas w rong to practice usuaryto charge interest on borrowed funds. Th e universe wasassumed to be static and ordained by G od. Each man had a set place in society withobligations and privileges prescribed for his station in life. Th e only purpose ofknowledge was to help people understand God's intentions in creating the universe.

The Great Transformation

The established order was strong and resistant to social change . It is not likely that asingle factor or event could have caused its demise. The transformation of the feudaleconomy of the Middle Ages into capitalism had to be caused by more or less thesimultaneous influence of many factors. This section will describe som e of those socialforces that played a role in the great transition to capitalism.PHILOSOPHICAL FACTORSStarting in the fourteenth century, the relationship between philosophy and religionbegan to be questioned. The process of alienation started with no min alism, an early andprimitive attempt to question the dependence of philosophy on th eolog y. The idea ofthe separation of philosophy from theology gained momentum with the development ofthe scientific method. Francis Bacon (1561 -162 6), David Hume (1 711 -177 6), and JohnLocke (1632-1704), among others, raised the issue of the supremacy of reason andknow ledge ove r the revealed truth. Their objective w as to enhance our understandingof the wor ld. Bacon claimed that man 's perfection depends on the progress of scienceand its application to human life. Lo cke argued that the state should support naturallaw s and that within this structure the individual should have free re in. Hume defendedprivate property rights.Descartes (1596-1650), Newton(1642-1727)andComte(1798-1857), among others,emphasized the importance of mathematics and scienc e. Desc artes claimed thatmathematics could be extended to all scien ces, including philosop hy. New ton wasconcerned with the rules of reasoning in philosophy. Com te argued that actualknow ledge depends on testing and experimentation. Immanuel Kant (17 24 -18 04 ), aleading rationalist in the eighteenth century, insisted on the authority of science.


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10Those philosophical developments in Western Europe were the result of a desire toimprove understanding of the world by emphasizing logical thinking, science andexperim entation. In doing so , the thinkers of the time and their theories initiated aradical departure from centuries of medieval tradition.

THE RELIGIOUS REFORMATIONTh e religious reformation had a profound effect on the relationship between ethics andecon om ics in the Middle Ag es . It sanctioned the spirit of acquisition and justified theaccumulation of w ealth. M oreover , it undermined the Catholic Church monopoly inmatters of faith.

Martin Luther (1483-1546) advocated a frugal, hard-working life and provided thespiritual foundation for the work ethic. John Calvin (1 50 9-15 64 ) taught that to provehimself among the chosen, man has to work hard, be frugal, and seek success in his"calling." He gav e religious sanction to the accumulation of wea lth. The Puritan spiritgave a tremendous impetus to the development of the frugal, hard-working, andaccumulating ind ividual. It is interesting to note that capitalism first developed in twocountries with Puritan popu lations: England and Ho lland.Philosophical factors and the Reformation emphasized reason , scienc e, know ledge,experimentation, hard work, savings, and the accumulation of w ealth. Slow ly, the ideathat the universe is fixed and ordained by God began to be overtaken by new ideas ofhuman progress and free will . By the second half of the eighteenth century, the worldwas ready for Adam Smith to turn the age of reason toward a better understanding ofeconomic processes.NEW FRONTIERS**New" philosophy ga ve birth to new ideas. H ow eve r, tradition in Europe was strong.The old order, with its custom s, class privilege s, and medieval va lues, was powerful andresistant to new ideas. Traditional Christianity w as too deeply rooted to be so quicklyaltered. M oreover, Europe was also quite poor and overcrowded to have "room" forthe new ideas to be given an empirical test. In short, the new ideas lacked space to betried out. The exploration and settlement of new frontiers, primarily the Am ericas,provided an excellent "laboratory."The most important contribution of new frontiers to the rise of capitalism was inproviding a tradition-free space in which to test new ideas. Freedom from religiousconstraints, from humble origins, and from traditional ethics allowed thousands ofpeople to pursue their individual preferences, to be responsible for their own actions,and to create their own place in a new society. Once those ideas were applied toeveryday life and proven su ccess ful, they traveled back to Europe and contributed to thetransformation of medieval man into modem man.In addition to providing a tradition-free space for the application of new ideas, thenew frontiers made an additional contribution to the rise of capitalism. Of every $1 00worth of gold and silver produced in Western Europe and newly-opened territories after


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111495 , $85 worth was produced by the new frontiers. Taking precious metals and othergoods to Europe was risky, but for those who were lucky, a 1000 percent rate of returnwa s not uncom mo n. An unintended result of this individualrisk-taJdngwas to give newideas a chance to demonstrate their social and economic consequences.The people who went to America in those early days were often referred to ascriminals. Indeed, they were criminals by the prevailing standards of the day, when itwas a crime to oppose the established order, reject medieval tradition, complain aboutthe role of the Church in secular affairs, or avoid taxes imposed by monarchs andbishops . M ost settlers cam e to Am erica to escap e those feudal restrictions. The y hadwhat was considered to be a rebellious desire to live their own lives, make their owncho ices , and write their ow n m orals. So they escaped to the tradition-free space of thenew frontiers.SOCIOLCX5ICAL FACTORSCapitalism requires entrepreneurship, wage labor, and a positive attitude toward work,none of which existed, in an institutional sense, in the Middle Ages.M edieval nobility could not supply entrepreneurship. Its concerns we re wars,politics, and leisure. It was degrading for a nobleman to engag e in comm ercialactivities, trade, and crafts. He w as bom to be a lord, a hunter, a warrior, and a lover.The business class emerged from the ranks of small traders and artisans. Th ose p eoplewere env ious o f all the status, privileges, and wealth enjoyed by the nobility and wantedto draw a line between them selves and the lowe r class of peasants. In the quest forstatus and influen ce, small traders and artisans turned their attention to the accum ulationof w ealth. In the process, they laid out the foundation for the em ergence o f the middleclass, a major source of entrepreneurship in capitalism.The labor force emerged from s ev er ^ sour ces. The rate of growth o f the populationin Europe in the aftermath o f the Black Death was an important factor. With anincrease in the population, the marginal productivity of labor fell relative to the valueof land. This change in the econo mic conditions of life provided incentives for the landowning aristocracy to replace the feudal system with the nontransferable right ofownership that tied peasants to their land, with private transferable ownership in land.Enclosures of commons, or public grazing lands, and other methods of throwingpeasants off the land were an important source of the labor supply. Am ong the otherfactors that led to an increase in the labor force were improvements in health care, thegradual disappearance of private armies and guilds, and child labor.The rise of capitalism also required a positive attitude toward work. In the writingsof medieval theologians and philosophers, workers were usually called the "laboring"poor. In the schem e of social values in the M iddle Ag es , begging and physical laborwere considered two traditional methods of survival for the poor. The religiousreformation w as responsible for a change in this attitude. By g iving a strong re ligioussanction to hard work, the Reformation divorced productive work from w elfare. M an'sattitude toward work became an important measure of his character and integrity.


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12CAPITAL FORMATIONOn the supply side, two major sources of investable funds are private savings and bankcredit. Neither existed in the M iddle A ge s. Private wealth was spent on the church,palaces, private armies, luxuries, heirs, and many other activities, but not on investment.The Reformation had a strong influence on the supply of private savings. To provehimself among God's elect and avoid temptation, man had to work hard and livefrugally. Th us, a religious sanction for the accumulation of w ealth opened the door forprivate savings.Medieval banks did not give investment credit; their major functions were tosafeguard deposits and transfer them from one account to another. This failure ofmedieval banks to create bank credit is, according to Schumpeter, the late Harvardecono mist, a major reason that Italian cities, such as Florence, Gen oa, and Venice, werenot able to sustain their prosperity. The development of the modem banking systembegan in 169 4, when the Bank of England was founded. It gained momentum in 17 97,when the British government forbade the Bank to pay its notes in gold, opening the doorto a fast increase in the volum e of bank credit. When the gold standard was reimposedin 1821, the institution of bank credit, a vital source of capital formation, was alreadyfirmly established.

To conclude, the great transformation of medieval man into modem man broughtabout a new socioeco nom ic system . Many factors contributed to this transition. Mostof those factors were not new . Reason played an important role in Greece; propertyrights were fully developed in old Rome; and free trade had long been practiced and itsbenefits savored in the M iddle East. But it wa s when these factors coalesced in Europethat capitalism had its birth. Early writers called the new system laissez-faire andequated it with individualism and industrialization. Adam Sm ith called it the NaturalSystem of Econom ic Liberty. He described the system as being self-generating, self-prop elling, and self-regulating. It rests on the idea of individual liberty, the freedomof ch oice , self-determination, and self-responsibility. The term capitalism was used byMarxists with a tone of ethical and social disapproval.S U G G ES TED R EA D IN G S

Gilso n, E. The Spirit of Medieval Philosophy . New York: Scribner, 19 40.Brinton, C . The Shaping of the M odem M ind. New York: N ew American Library ofWorld Literature, 1959.M eckling, W . "Science and Religion: Evidence or Faith," paper presented at the 4th F.Hayek Symposium on Knowledge, Evolution and Competition, Freiburg, 1990.Webb, W . P . "Ended: 40 0 Year Boom: Reflection of the A ge o f the Frontier," HarperMagazine. October, 1951.


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13W eber, M . Th e Protestant Ethics and the Spirit of C apitalism. N ew York: Scribner,1960.


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CHAPTER 3THE RISE OF SOCIALISM

Catholic theologians and socialists were the most serious critics of early capitalism.They rejected one of the most fundamental premises of capitalism: methodologicalindividualism. Because early socialist critics built their case against capitalism on themoral teachings of the Church, a section of this chapter will deal with the positions ofearly Catholic philosophers.Catholic philosophers and socialists believe that each community has a commongood; that is, a system of ends representing all absolute social values. Therefore, theprevailing institutional arrangements and rules of the game must channel the behaviorof individual members of the community toward the pursuit of the common good. Thecommunity is then conceived as an organic w hole in which each individual is expectedto subordinate his private ends and cooperate with others in pursuing the common good.The classical liberal (capitalist) community has no common good. It is a voluntaryassociation of individuals who join and leave the community in pursuit of their ownprivate ends. The interaction of utility-seeking individuals in a capitalist communityleads to an unintended ou tcome. The rules of the game in the capitalist community arenot developed to serve some preordained common good. The emphasis is on the processof choosing the rules and their acceptance by the comm unity. If the rules of the gameare fair, their "unintended" outcomes will also be fair.

Capitalism and Catholic niilosophy

Catholic philosophy has raised the issue of the legitimacy of capitalism as a moralsystem. The origin of this issue lies in the basic difference between the Catholic andthe capitalist concepts of community. The capitalist comm unity is a voluntaryassociation of individuals who, in the pursuit of their own private ends, join and leavethe community as they choose. Catholic philosophy considers the community as anorganic whole whose members cooperate with each other in the pursuit of a prescribedoutcome (common good).What classical liberals considered as the freeing of man from the constraints ofmedieval tradition. Catholic philosophers saw as the erosion of morality and rejectionof "absolute" values. Catholic philosophy is apprehensive about freedom of choice, notbecause of any lack of interest in individual liberty, disregard for private rights, orindifference to economic efficiency, but because of a fear that the autonomy of


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16individual choices in the free m arket does not necessarily generate morally satisfying setsof preferences. Catholic philosophy tends to gloss over the fact that the free marketdoes not generate preferences. It could be said that those who are critical of thefreedom of individual choice which the capitalist system allows should direct theircriticism toward the institutionssuch as schoo ls, churches, households, the streets, themediathat form the preferences, rather than toward the free market in which thosepreferences are merely revealed. Suppressing the freedom of choice does not changea pe rson 's character. It merely deprives the person of a right to make a choice consistent with personal preference and bear the cost (e .g ., losing friends) of the action taken.In fact, the free market has a strong moral content. It promotes the developmentof individuals, cultivating strength from confronting risk, and places a high value on thekeeping of prom ises. A reputation for honest dealing is a source of wealth. Incompetitive markets crooks, cheats, and liars do not get repeat business. While the freemarket does not make people moral, it raises the cost of unethical behavior. Arguingthat many moral norms satisfy the requirements of efficiency. Judge Posner writes:

Honesty, trustworthiness, and love reduce the cost of transactions... .Neighborli-ness...reduces external costs....Charity reduces the demand for costly publicwelfare program s. Care reduces social waste. (R. Posner, Economic Analysisof Law. Boston: Little, Brown and Co., 1986, pp. 238-9)

Early (Pre-Marx) Socialists

SIR THOMAS MORE (1478-1535)Thomas M ore was the first significant critic of capitalism. In his writings he tried totie what we now call socialism to the moral teachings of the early church fathers.More opposed the transformation of the traditional society into a money economy.He realized that the world was changing but argued that changes must be made withinthe bounds of the moral teachings of the Church. On a practical level, More believedin primitive communism. Medieval philosophers and early socialists defined primitivecommunism as a society in which all resources are held in common and no member ofthe community is allowed to accumulate private wealth. By establishing commonownership of all resources. More believed, the problems of the emerging industrialsociety could be resolved or avoided. More also believed that private property righ tsmake a just government impossible. Private property righ ts, he claimed, lead to socialinequalities, which generate behavior that is contrary to divine law.M ore's alternative to the emerging capitalist society was Utopia. In Utopia,agriculture is the most important industry. All citizens, including those living in thecities, must spend some time working on collective farms. The supply of goods for allcities is to be calculated in advance, and their citizens have to work on the farms inproportion to their cities' food needs. Every month a member of each family would be


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17required to take the goo ds produced by the family to the market. In excha nge, thefamily would receive coupons which it would exchange for other goods in the market.Travel would not be unrestricted in Utopia. To travel from on e comm unity to anotherwou ld require perm ission. And the traveler would have to do a da y's work at hisdestination.FRENCH SOCIALISTSIn the seventeenth and eighteenth centuries, France was fertile ground for socialist ideas.Unlike Thomas More, who wanted to retreat from capitalism and return to the customsand morality of the old order, French socialists accepted the reality of the risingindustrial society and raised a different question: What can be don e to eliminate thesocial and economic inequalities that capitalism had produced?Comte Henri de Saint-Simon (1760-1825) and Pierre-Joseph Proudhon (1809-1865)we re the most prominent French socia lists. Saint-Simon participated in the Am ericanRevolution and was decorated for bravery during the battle of Y orktow n. His primaryobjective was to find a way to guarantee equal opportunity rather than economicequality, and he believed that the way to achieve this ideal was through collectiveown ership. A s a result of his conclus ion, he directed his major criticism o f capitalismat private property rights. Long before Marx, Saint-Simon advocated "from each manaccording to his ability; to each man according to his contribution."

Proudhon opposed all forms of governm ent. He is often regarded as the foundingfather of anarchism. Like all other socia lists, Proudhon opposed private property rights.But, unlike Saint-Simon, he believed in actual economic equality.AMERICAN SOCIALISTSSocialists in the United States were few in number and had little influence. GeorgeRipley (1802-1880), a Unitarian minister, bought a two-hundred-acre milk farm inMassachusetts where he planned to replace competition w ith cooper ation. The com munemet its demise within a few yea rs. Another com mu ne, the North Am erican Phalansteryat Red Bank in New Jersey did not last long either.In the late nineteenth century, Eugene V. Debs (1855-1926) organized the SocialDemocratic Party of America and ran as a socialist for president in all elections from1900 through 1920 . The party and D ebs met with little suc cess .Although socialism per se has never been popular in the United States, welfarelegislation such as the New Deal, Social Security, and unemployment insurance has hadsom e public support. In the United States most po licie s that can be tagged "socialist"have aimed at redistribution of income rather than changes in the institutions ofcapitalism.Pre-Marx socialists were by n o m eans in agreement in their vie w s on capitalism andsocialism . Yet there was one capitalistic concept which they all condem ned: privateproperty rights. Their common line of reasoning behind this condemnation was thatnature is good , and thus, the world must be go od . It follow s that peo ple should be able


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18to live in peace and harmony. To create a "just** society in this inherently good w orld,the early socialists believeii that rulers had merely to use reason, goodwill, andknowledge.It is precisely on the issue of the role of reason that the most important differencearose between early socialists and Karl Marx.

Marxism

Karl Marx (1818-188 3) was bom in the Rhineland, Germany. He w as one of sevenchildren in a Jewish family that embraced Christianity when he was six years of age.He studied philosoph y, history, jurisprudence, and literature in Bonn and Berlin. In1843, Marx set his goals:

...[my task does] not consist in the setting up of Utopias, but in the criticismof existing sociaJ and political conditions...in interpreting the struggles andaspirations of the age . (H. Laidler, A History of Socialist Though t. NewYork: T. Y. Crowell Co., 1927, p. 155)In tim e, Marx becam e the most influential critic of capitalism. It is thus important tounderstand some basic tenets of Marxism.INFLUENCES ON KARL MARXMarx was influenced by three contemporary movements: early French socialism,classical German philosophy, and classical British economics.Early French Socialists, French socialists believed that capitalism was an immoralsystem . They blamed capitalism for long working hours, child labor, the poverty ofworking p eop le, unemployment, income inequalities, social injustice and numerous otherproblem s. And they placed the ultimate blame for these problem s on private propertyrights. Th us, they argued that the simp lest way to do away w ith capitalism and the illsto which it seemed linked was to abolish capitalism's fundamental concept: privateproperty rights.Marx agreed with French socialists that capitalism was not a just system . Althoughhe also agreed that the right of ownership creates most social problems, he consideredit naive to think that socialism, once discovered by reason, could conquer the worldsimply by promising justice and harmony. Marx drew a line between the preference forsocia lism and the scientific analysis of its place and role in human history. The fallacyof reason, Marx said, is that it ignores the laws of history; even the best idea has toawait its moment in history.


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19Classical German Philosophy. The great thinkers of the Middle Ages conceived of theuniverse as constant and eternal. Eventually, h ow eve r, scholars began to realize thathuman history revealed an endless evolution o f social institutions. Th is discovery thatthe universe is not immutable generated interest in analyzing social chang e. The roleof reason became one of analyzing history and discovering the truth about the world.Hegel (1770-1831) was a leading philosopher among those who tried to formulatea theory of social change. His central thesis wa s that a prevailing set of ideasdetermines our perceptions about the world in which we live . Th ese comm on ideasshape our social institutions, the way we interact with each other, and the organizationof production and distribution of good s and service s. The essen ce of He gel'sphilosophical m ethod was the concept of dialectics: Each idea has its inner contradiction, and w ithin each idea there is a conflict between its positive and n egative elem ents.It is from this internal conflict inherent in all ideas that a new idea eventually emerges.This new idea is not an extension of the old one; it is a qualitatively different concept.The new idea then slowly but surely reshapes all aspects of social life.Marx accepted Hegel's thesis that human history is shaped by social changesgenerated from within the social system itself. However, he disagreed with Hegel asto the role of ideas in producing social change, believing instead that the economicconditions of life determine our politics, social institutions, and, m ost significantly, ourphilosophy , religion , and ideas. He m oved H ege l's concept of progress from the sphereof ideas to the material world. Appropriately then, Marx's m ethod of an alysis is calleddialectical materialism, which says that (i) all things and phenomena of life are in aconstant process of evolution; (ii) all things and phenomena of life are interconnected;(iii) the process of social change occurs through a struggle of opposite tendencies; and(iv) human progress consists of the gradual accumulation of small quantitative changesthat lead to a major qualitative change.In Holy Family, published in 1844, Marx used dialectical materialism to describethe transition from capitalism to socia lism . In the struggle between private property,which is the positive element in capitalism, and the rising proletariat, which is thenegative element (inner contradiction), the latter will triumph by abolishing both itselfand private property rights. Socialism will then have replaced capitalism.Classical British Economics. Marx was influenced by David Ricardo (1770-1823), fromwhom he borrowed the labor theory of value . This theory basically said that the valueof any commodity is proportional to the average number of labor hours needed for itsproduction. Th us, only labor creates new value; the contribution of capital to the valueof a product is equal to its wear and tear. For exam ple, under the labor theory of va lue,a serving of beer will be worth twice as much as a soft drink if its production requirestwice as many labor hours.Marx modified the labor theory of value to suit his purpose of explaining the returns(profits) to private property. He said that if the valu e of any good is determined by theaverage number of hours needed for its production, the value of labor must also bedetermined by the average number of hours needed for its production. To summ arize.


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20each day a worker uses up so much of his energy, which must then be replenished sothat he is able to work the next day. H e must also be able to support children toeventually replace him in the labor force. The market wa ge is then the amount ofmoney that is just sufficient to buy the minimum amount of goods needed for thewo rker's maintenance. Or, put another way , the market wage must be just sufficientto ensure the supply of labor in the long run. The v alue of this **bundle of goods'* is theaverage number of labor hours needed to produce it.Suppose the working day is ten hours, but that it takes only five hours to producethe minimum bundle of go ods the worker must receive each day. In ten hours, hecreates the value that brings the employer (that is, the property owner) the amount ofmon ey equal to ten labor-hours. The em ployer pays the worker the wage that is equalto the value of five labor-hours. Th e difference between the number of hours theworker labors each day and the number of hours it takes to produce the minimum bundleof go od s that he must have each day is the surplus value. The surplus value i s returnedto the class of property own ers as profit. In the Marxist vie w , h ow eve r, that return iscreated by labor.THE ECONOMIC INTERPRETATION OF HISTORYMarx believed that economic processes explain the entire history of mankind, a historywh ich he saw as a continuous strugg le of inferior man against superior nature. Triggered by man's survival instincts (i.e., desire for more utility), this struggle has as itshistorical purpose the reversal of the original relationship between man and naturethrough the process of the production of economic goods.Th is historical sequence begins with primitive society . There, man is totallydependent for his econom ic survival on an alien and hostile environm ent. All effortsin a primitive society are geared toward the restricted objective of subsistence, that is,toward the appropriation of products in their natural state. W ithout innovation,prim itive society merely reproduces itself through time. How eve r, man's survivalinstinct leads him to seek wa ys to produce subsistence more efficiently: the discoveryof fire made fish an important source of nourishment, while the bow and arrowincreased returns from hunting. As man learned how to use intermediate good s (tools)to increase the supply of food for subsistence, two related developments had to occur.First, each time man uses a new tool (primitive hammer, arrow, or modemcom puter ), he takes a step toward freeing himse lf from dependence on nature. Thehistory of mankind is, then, a long journey from man's complete economic subordination to nature to his ultimate mastery over nature. Th is last stage in m an's journeythrough history Marx called comm unism . It was not a political or ideolog ical socialstructure but a definite stage in the relationship between man and nature. In today'sjargo n, M arx's comm unism could be called a world without scarcity. At any rate, theeco no mic interpretation of history has, then , a strong pseu do-re ligious content: salvationwill happen in this space and time.Second, as people learned how to produce and use tools, it became necessary forthem to regulate access to those tools in ways that would encourage their production.


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21To define who has what access to an asset means to define property rights in that asset.In this manner, Marx explained the history and development of property rights.We can thus say that Marx deduced the historical necessity of property rights from(i) the initial alienation of man to nature, and (ii) his (survival) instinct to reverse thatrelationship. Property rights did not deve lop becau se a few w ise men "discovered" theirimportance. Marx argued that property rights are developed and modified in resp onseto changes in the economic conditions of life. Th is point defines a very important difference between Marx and early socialists. Marx emphasized the inevitable (necessary)laws of history and played down the role of reason.While the importance of property rights was recognized by social scientists beforeMarx, he wa s the first to have a theory of property rights. M arx's analytical apparatuswas primitive and his deterministic view s of human history untenable. Yet, he was ableto perceive the importance of property rights with regard to the production anddistribution of goods, to recognize that property rights are endogenous to the system,and to sense that property relations affect human behavior in specific and predictablewa ys. Thu s, M arx made a contribution toward better understanding of e cono micprocesses. In a major attack on classical political econ om y, Marx wrote:

Political economy proceeds from the fact of private property, but it does notexplain it to us. Political econom y exp resses in general, abstract formulae thematerial process through which private property actually passes...it takes forgranted what it is supposed to ev olve . [Private property] is explained fromexternal circumstances. As to how far these external...circumstan ces are butthe expression of the necessary course of [human] development, politicaleconomy teaches us nothing.THE PROCESS OF SOCIAL CHANGETo explain the process of social change, M arx used two concepts: (i) relations ofproduction and (ii) productive forces.

In its long journey from complete dependence on nature to mastery over nature, allhuman society must pass through som e definite types of property relations. Marx usedthe terms relations of production and property rights interchangeably and defined thisconcept as the relations among m en in the proce ss of produ ction, wh ich today, w e w ouldcall a social syste m. Through the history of mankind before the final stage is reached,these relations of production are relations among a liens . Private property causes thisalienation of man from m an. M arx's analysis of the concept of alienated labor, one ofhis key concepts, can be summarized as follow s: (i) Since it doe s not belong to him,the product of the worker's labor appears to him to be an alien object, (ii) Consequen tly, the worker considers his work to be imposed labor. Thu s, the worker is alienatedfrom his work activity, (iii) What distinguishes man from animals is his consciou s lifeactivity. But alienated labor turns man's life activity into a means of ex istenc e. Italienates man from his spe cies ' life, (iv) Th e worker is alienated from that other manwh o takes the product away from him. (v) Th ose tw o men wh o are alienated from each


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22Other belon g to identifiable social cla sses. The class struggle is then a major consequence of private property rights.Economic development changes the relationship between man and nature in theproduction of goods and servic es. Marx called this relationship productive forces. Theproductive forces represent the relation between man and nature in the production ofgood s and services. In the concept of productive forces Marx included technology, thesupply of resources, working habits, and education.Given the prevailing social system, man's survival instinct brings about improvements in the forces of production. A change in the forces o f production means that manbecom es a little less dependent on nature. Marx argued, how ever , that at some level ofeconomic development the prevailing social system will become a fetter to furtherimprovements in the forces o f production. Then and on ly then the prevailing socialsystem w ill break dow n, and a new social system w ill em erge . This new system ofproperty rights will accelerate economic developm ent. But, at som e level of economicdevelopm ent, the system that was initially a progressive o ne will once again becom e anobstacle to further econom ic developm ent. The cy cle repeats itself until the final stageis reached.

In its journey through history, mankind must pass through definite types of"property relations." Each social system has its historical function to perform. Thus,each system has its birth, life, and death. Marx was firm in say ing that a system cannotbe born before the old one has performed its historical function , and it will not disappearbefore its own historical contribution to the progress of mankind has been fully utilized.At a certain stage of their development, the forces of production come intoconflict with the existing property relations....From forms of development ofthe forces o f production these relations turn into their fetters. Then com es theperiod of social revolution. With the change of the eco nom ic foundation, theentire...superstructure is more or less rapidly transformed. (K. Marx, "AContribution to the Critique of Political Economy," in Marx and Engels. BasicWritings on Politics and Philosophy (L. Feuer, ed.). Garden City: Doubleday,1959, pp. 43-4)

According to Marx, the historical function of capitalism was the automation of industry(i .e. , high technology).Profit is a powerful motivating force in a private-property socie ty. It providesproperty owners with strong incen tives to increase productivity in their factories. Buthigher productivity comes from the development of efficient, cost-effective newmachines. Th us, in his search for more profit, a property owner continuously substitutesmachines for labor.Through this process of substitution of more-productive for less-productivemachines, the capitalist performs two functions. First, he contributes to econom icdeve lopm ent, w hich is a historical function of capitalism. Sec ond , he also contributesto the end of capitalism. How ?


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23While one capitalist is innovating and upgrading, other capitalists do not stand still.They also invest in better machines. How ever, as the number of workers employed fallsrelative to the amount of capital used by firms, the surplus valuewhich comes fromhuman labor onlyshrinks relative to the total cost of production. And the average rateof profit falls. A decline in the average rate of profit brings about an increase in thepercentage of the labor force out of work. In short, the profit motive pushes thecapitalist class to search for and implement more and better technology. The resultingincrease in the capital-labor ratio reduces the ratio of surplus value to total investmentby capitalism firms. The average rate of profit falls, creating additional pressure forindividual capitalists to recapture it by increasing the productivity of their firms relativeto that of their competitors. In the process, the industry gets automated, the labor force

shrinks, and the rate of profit approaches zero . At that point in time, the capitalistmachine would have performed its historical function. The impoverished workers wouldrise and throw out private property rights to the means of production. And a newsystem, socialism, would move in.Historical evidence, economic analysis, and recent developments in Eastern Europedo not support M arx 's analysis of the process of social change and its inevitability. In1987, Hans Albert^ provided an excellent analysis of the so-called inevitability ofsocialism.

SUGGESTED READINGSFeuer, L. (ed .) Marx and Engels. Basic W ritings on Politics and Philosophy. GardenCity: Doubleday, 1959.Laidler, H. A History of Socialist Thought. New York: T. Y . Crowell, 1927.Marx, K. Philosophical and Economic Manuscripts. Moscow: Foreign LanguagesPublishing House, 1960.Pejovich, S. (ed.) Socialism: Institutional. Philosophical and Economic Issues.

Dordrecht: Kluwer Academic Publishers, 1987.

*H. Albert, "Is Socialism Inevitable? Historical Prophecy and the Possibilities ofReason," in Socialism: Institutional. Philosophical and Economic Issues (S. Pejovich,ed.), Dordrecht, Kluwer Academic Publishers, 1987, p. 55-88.


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PART TWOTHE PRIVATE-PROPERTYFREE-MARKET ECONOMY


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CHAPTER 4BASIC INSTITUTIONS OF CAPITALISM

The basic institutions of capitalism are : (i) the right of ownership in productive assets,(ii) freedom of contract, and (iii) constitutional (limited) government. Those threeinstitutions set capitalism apart from other social systems. They generate incentives thathave specific and predictable effects on the behavior of decision makers, the allocationof resources, and the flow of innovation.

Private Property Rights

THE MEANING OF THE RIGHT OF OWNERSHIPAbout the righ t of ownership, I. Fisher said: "A property right is the liberty or permitto enjoy benefits of wealth while assuming the costs which those benefits entail....property rights are not physical things or events, but are abstract social relations. Aproperty right is not a thing ." (I. Fisher, Elementary Principles of Econom ics, NewYork: Macmillan, 1923, p . 27) Instead, property righ ts are relations among men thatarise from the existence of scarce goods and pertain to their use . This definition ofproperty rights is consistent with Roman law, common law, Karl M arx 's w ritings, andthe new institutional (property rights) economics.This definition of property righ ts makes two important points. The firs t is that itis wrong to separate human rights from property rights. My right to vote and my rightto speak on issues are my property rights because they define the relationship betweenmyself and other people. In other words, the property-rights definition applies to allrigh ts of an individual vis-k-vis other peop le. The second point derives from the first,in that property righ ts are relations between individuals. Suppose I own a computer.The right of ownership does not define the relationship between myself and thecomputer. It defines the relationship between myself and all other people with respectto the right to use the computer. Property rights specify the norms of behavior withrespect to economic goods that all persons must observe in their interactions with otherpeople or bear the penalty cost of non-observance.The right of ownership is a category of the general concept of property rights.Roman law specified several categories of property rights: ownership (the right to useone's property within the limits of law), the right of trespassing (the right to crossanother's land), usus fructus (the right to use a thing belonging to someone else or to


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28rent it to others, but not to sell it or change its quality), usus (the right to use a thingbelonging to someone else, but not to rent it or sell it or change its quality), and pawn(the right to keep a thing belonging to someone else but not to use it).The right of ow nership contains the following four elemen ts: (i) the right to use anasset (ususl, (ii) the right to capture benefits from that asset fusus fructus^. (iii) the rightto change its form and substance (abusus), and (iv) the right to transfer all or some ofthe rights specified under (i), (ii), and (iii) to others at a mutually agreed upon price.The last two elements are Uie most fundamental components of private propertyrights. They define the ow ner's right to bear changes in the value of his asset.Although the right of ownership is not an unrestricted right, it is an exclusive right inthe sense that it is limited only by those restrictions that are explicitly stated in the law.Those constraints on the right of ownership may range from substantial ones, such asprice controls, to minor restrictions, such as keeping the fence around one's house twofeet ins ide the property line. At this point, it is important to note that legal restrictionson the right of ownershipw hether justifiable or notreduce our set o f ch oices of whatto do with the goods we own.THE RIGHT OF OWNERSHIP AND ECONOMIC BEHAVIORThe right of ownership affects economic behavior in several important ways.The exclusivity of ownership means that the owner has the right to choose what todo with his asset (e.g., the right to speak on a social issue), how to use it (e.g., to beopposed to abortion), and w ho is to be given access to it (e. g ., to join an anti-abortionlobb y). The ow ner (or the people he appoints to do it on his behalf) d ecides what to dowith his asset (e.g., he authorizes a real estate agent to sell his home); he captures thebenefits of h is decision and bears its cost. The exclusivity of ow nership creates a stronglink between one's right to choose how to use assets and bearing the consequences ofthat choice.The right of ownership then creates strong incentives for the owner to seek thehighest-valued use for his resources. The world is full of observations that support thisproposition. People take better care of hom es they own than of those they rent. Theyare more likely to check and add oil to their own cars than to those they rent. I havetwo com puters. The computer at hom e is mine while the one in my office belongs tothe university. They render absolutely the same flow of serv ices to m e, yet I do nottreat them equ ally. I have more rights in the hom e, the car, and the computer that aremine.The transferability of ownership means that the owner has the right to transfer hisasset to others at mutually agreed upon terms. That is , he can sell his asset or giv e itaw ay. What are some of the implications of this second compon ent of the right ofownership?Suppose M s. Sm ith is a farmer. She makes about $1 ,0 00 p er year after directexp ense s. M s. Jones could earn a profit of $1 ,5 00 farming the same land. A transferof the farm from a less-productive farmer to a more-productive farmer would clearlybenefit the com mu nity. The transferability of ownersh ip prov ides incentives for


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29resources to seek the most productive ow ner s. W hy? Assum ing a rate of interest of 10percent, M s. Jones is willing to pay up to $1 5,0 00 for the farm, w hile M s. Smith w ouldhave incentives to sell her farm at any price above $10,000.The constitutional guarantee of ownership divorces economic wealth from politicalpower. A s Ivan moves up the Soviet power structure, his econom ic well-beingincreases. He gets a better apartment in the city, a bigger week end hom e in the country,the right to a more exclusive summer resort, access to special stores, and many otherbenefits that are directly related to his position in the Sovie t hierarchy. If Ivan is kickedout of the Sov iet pow er structure, he loses all eco nom ic benefits. Things we re not muchdifferent in feudalism . Rising or falling in the political pow er structure had a directeffect on on e's econom ic wealth. H ow ever , the right of ownership breaks this linkbetween power and wealth in capitalism. The individual wh o loses political pow er doesnot lose his economic wealth.Political power is not the exclusive road to economic wealth in socialism, and theseparation of pow er from wealth is far from being perfect in capitalism . But, ingeneral, a major consequence of the absence of private property rights is a marriage ofpolitical power and wealth, and a major consequence of the right of ownership is theirdivorce.Exclusivity provides incentives for those who own assets to put them into thehighest-valued uses; transferability provides incentives for resources to m ove from less-productive to more-productive owners; and the constitutional guarantee of ownershipseparates the accumulation o f econ om ic w ealth from the accumulation of p olitical pow er.NEW INSTrrUTIONAL ECONOMICS (PROPERTY RIGHTS ECONOMICS)The standard theory of production and exchan ge rests on three prop ositions: (i) privateownership of all resources, (ii) zero transaction costs, and (iii) downward-slopingdemand schedules for good s. The first proposition is sp ecific to the capitalist system,the second is an assum ption, and the third captures the essen ce of human behavior in aworld of scarcity (i. e. , in all societies). Starting with those three propo sitions, thestandard theory of production and exchange has provided important insights into themeaning of the social choice set, the conseq uences of ec ono m ic efficiency, the types ofmarket competition, and the properties of market equilibriums.How eve r, in the standard theory of prod uction and excha nge the output is a functionof the costs of a set of inputs, given the state of technological kn ow ledge. But this viewis misleading beca use production does not take plac e in an institutional vacuum. If theoutput of an economy depended only on the costs of the traditional inputs and somegiven production function, economic analysis could not explain persistent economicdifferences between various countries. Th e fact is that output is a function of the costsof production, which consists of the costs of the traditional inputs and the costs oftransacting. Y et, the standard theory of production and exchan ge makes no allow ancefor the effects of alternative property rights on transaction costs, income distribution,and incentives to innovate. For examp le, the production-and-exchange theory has madetechnical innovation an external phenom enon. It leav es the expansion o f the choice set


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30outside the scope of economic analysis and deals with the effects of technical changeonly after they have been introduced into the economy.It would be wrong to discard the standard theory of production and exchange. Butit is also wrong to use it mechanically across a broad range of issu es. The new theoryof institutions has expanded the scope of applicability of the standard theory to a widerclass of real-world events.The key concepts underlying the new theory of institutions assert that (i) theconcept of the right of ownership is not the only relevant configuration; (ii) alternativeproperty rights affect the allocation of resources and the flow of innovation in specificand predictable wa ys; and (iii) transaction costs are positiv e. Transaction costs includethe costs of negotiating and monitoring economic behavior, the costs of obtaininginformation, the agency costs, and the costs of maintaining prevailing institutions.The Law of Contract

THE MEANING OF CONTRACTSPeople enter into contracts because they expect that exchange will make them better off.When I buy a pair of shoes for $50 or read a book, I am in effect saying that I expectmy choice of shoes or the book to give me more satisfaction than whatever utility Icould have obtained from spending the same amount of resources, including time, onanother bundle of go od s. Contracts are means by which people seek, identify, andnegotiate opportunities for exchange. W hile the right of ownership creates incentivesfor people to seek the most productive uses for their assets, the freedom of contractreduces the cost of identifying them. The purpose of excha nge is then an aspect ofutility. In that sense, the purpose of exchange is independent of the prevailing propertyrights. Ho wev er, the extent and terms of exchang e are not.THE LAW OF CONTRACT AND ECONOMIC BEHAVIORThe law of contract serves three fundamental econ om ic functions . First, it actualizesthe relationship between the prevailing property rights and economic value. Secon d, itencourages excha nge that is not simultaneous. Fina lly, the law of contract reduces thecosts of exchange.The prevailing legal institutions determine the bundles of rights that could betransferred (i.e., any deviation of contractual agreements from the prevailing propertyrights is not enforceable) by way o f contractual agreemen ts. Since the bundle of rightsheld in various g ood s affects their market prices, the prevailing property rights constrainthe extent of exchange and influence the terms of trade in specific and predictable ways.Being the means by which the bundles of rights are exchanged, the law of contract enhances the relationship between prevailing property rights and economic value.


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31Market transactions are frequently not simu ltaneous . Suppose that two individuals,A and B, want to buy my car. A offers to pay $1 ,0 00 at the time he takes possessionof my car, wh ile B prom ises to pay $1,50 0 a year later. If the difference b etween thetwo offers were not compensated by the market rate of interest, economic efficiencywould require that the car be sold to B. But I will choo se a less-efficien t alternative andsell my car to A unless the law enforces exchanges w hich are not simultaneous. Thelaw of contract, by holding people to their promises, encourages the optimal level ofeconomic activity.Most transactions have consequences that occur after the exchange agreement isconcluded. Buying a car, purchasing a home , getting m arried, signing up for a class ineconomics, and even eating out are exchange activities that have future consequences.

The problem is that future consequences often differ from those that were expected atthe time of the agreement. Som e risks are foreseeable, som e have a low probability ofoccurring, som e losses are difficult to foresee, and some are not foreseeable. But theyall increase the cost o f contracting. If legal contracts had to be drawn up for each andevery possible future contingency of a transaction, the extent of exchange in thecomm unity cou ld be reduced. Fortunately, this is not the case. All sorts of standardized contracts, trade customs, warranties, and return privileges reduce the costs of exchange by assigning in advance the losses and gains of the various contingencies.To summ arize, the law of contract enhances the movem ent of resources from lower-to higher-valued uses by (i) holding people to their promises and (ii) reducing the costof transacting.

Limited Government

THE GOVERNMENT IN A CAPITALIST SOCIETYCapitalism emphasizes the right of individuals to make choices according to their ownpreferences under constraints that include rules. Clea rly, the individual choice setdepends on laws and regulations imposed by all levels o f governm ent. The term limitedgovernment means that what the government does is more important than its size.The primary function of government in a capitalist society is to monitor the gameand enforce the rules, rather than to make them as the game is played. Th us, the roleof government in a capitalist society is basically a passive one, which could also bedescribed as one of maintaining the environment in which all individuals are free topursue their self-interests, make their ow n decis ions, and bear the consequenc es o f thosedecisio ns. Limited government also means that any changes m ade in the rules have tobe slow, deliberate, and based on the constitution, not on the basis of a majority vote.A football game can be compared to governm ent. In football the rules of the gam eare set, and spectators know what to watch for because they know the rules. Theplayers know the rules, and they know ho w to prepare for the gam e. The coac hes knowhow to coach within the rules. They have no freedom to change the rules; they have


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32the freedom to choo se to play within the rules. Suppo se that the blue team is drivingdow n the field and is at the two-yard line. They use the fourth d ow n, and the coachsays to the referee, "My players worked so hard, why don't you give them anotherdown?" The referee agrees to do so, and the blue team win s the gam e. In the short runthey have a victory; in the long run, they lost, because next time they will not knowhow to prepare for the gam e. Instead of hiring a coac h w ho can prepare them for thegame, they will have to hire a coach who can persuade the referee to change the rules.The em phasis w ill then be on em ploying people wh o know how to commit resources tochange the rules rather than on employing the most efficient people who know how toplay the gam e within the given rules. That will destroy the gam e.The case of M iller et al. v s. Sch oene is a goo d exam ple. For years, Virginianswe re free to grow apple trees and red cedar trees on their land. Then a fungus appearedthat grew on cedar trees but caused no harm to them. Ho wev er, the fungus w as capableof inflicting severe damage on apple trees. The prevailing rules contained no provisionforbidding the red cedar owners to grow them. H ow eve r, the state legislature ruled (andthe courts upheld the rulings) that the state biologist had to investigate and, if necessary,condemn and destroy without compensation certain red cedar trees within a two-mileradius of an apple orchard. In effec t, the state introduced a new rule that wa s clearlyin favor of the apple growe rs. The state's reaction to the problem wa s typical of thestandard social welfare approach. Ho wev er, it wa s inconsistent w ith the role of government in a capitalist state. James Buchanan made a very instructive comment on thisissue:

...when the parties are allowed freely to bargain and to reach mutuallysatisfactory agreemen ts, the apple grower's o wn assessment o f probable damageto his crop becomes the measure of his own maximum payment to secure theelimination of the danger. On the other side, the cedar grow er's ow n estimateof the value of his standing trees over and above their value as cut treesbecomes the basis of possible willingness to accept or reject profferedcomp ensations. The equity or inequity of compensation is irrelevant; what isrelevant is the necessary place of compensation in the trading process betweenthe two parties. Only when transfers are actually made can relative values bemeasured by those wh ose interests are directly invo lved . [In a capitalistsociety] there is an explicit prejudice in favor of previously existing rules, notbecause change itself is undesirable, but for the much more elementary reasonthat only such a prejudice offers incentives for the emergence of voluntarynegotiated settlements among the parties them selves. Indirectly, therefore, thisprejudice guarantees that resort to the authority of the State is effectivelymin imized . (J. Buchanan, "Politics, Property and the Law ," Journal of Lawand Economics. 16, 1972, pp. 439-452)


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33LIMITED GOVERNMENT AND ECONOMIC BEHAVIORFrom an individual's point of view , rules yield a flow o f benefits: the predictability ofother peo ple's behavior. Rules are cos tly, to o. The cost borne by an individual is thesatisfaction he forgoes by not being able to enga ge in some specific a ctivities. The flowof benefits from rules depends on their stability. A s time go es b y peop le becom e betterand better acquainted with the rules. They learn how to adjust to the system , identifyexchange opportunities, and exploit the most beneficial o ne s. For examp le, second-yearstudents get more out of the system of rules than freshmen . Ho we ver, if the schoolschanged the rules every year, the never-ending process of ''learning*' the rules wouldimpair the system's ability to enhance the flow of benefits.

The purchase of land, investment in plants and equipm ent, and many other exchangeopportunities have long-run consequen ces. Since frequent chan ges or expectations aboutchanges in the rules of the game would increase the risk and uncertainty associated withthose decisions, the cost of exchange opportunities that have long-term consequenceswou ld increase relative to those transactions that have a shorter time ho rizon . Th us, forexample, Jews in Central Europe before World War II favored investments in jewelryand other short-term, liquid asse ts. South Am ericans, seeing unstable political systemsaround them, prefer lower returns from investments in the United States to the muchhigher rates of return that are available in their hom elands. An invest

Documents

S. Pejovich_The Economics of Property Rights