THE INCENTIVE TO INNOVATE UNDERALTERNATIVE PROPERTY RIGHTS

Steve Pejovich

IntroductionThe Ideaof economic developmentdominates boththe aspirations

and the public policy of most countries today. However only capS.talist countrIes have done something about it The United States,Western Europe, Japan, Hong Kong, and a fewother places are trueIslands of economic affluence In a world that is terribly poor. Ifoverpopulation hascreated povertyIn India, whyare people In HongKong so much better off? If an Inadequate resource base Is respon-sible fOr poverty In China, why is a resource-poor country like Japandoing so well? The Soviet Union is well-endowed with resourcesbut its leaden are having a rather bard time clothing, feeding, andhousingtheir people. For centuries theTexas plains were amongthemost uninviting areas of the world; that Is, until the incentive eflOctsofa private property, capitalist economy transformed them into oneofthe most affluent regions on earth.

Itis amyth to assert that the shortage of capital is holding backeconomic development In Eastern Europe, Africa, andAsIa. CapitalIsaverymobile resource which Is continuously anduntlrlngly look-Ing forhigher yield opportunities. The flow ofcapital from theNorthto the South and from the West to the Easthas not been sufficient toequalizemarginal yields, because ofpolitical instabilities, currencycontrols, and/or attenuated property rights innoncapitalist countrIes.Also, governments of many countries have either inflated theirrespective economies, or overtaxed their people, or mortgaged theircountry’s resources to foreign creditors, and all of that in the nameof economIc growth. High growth rates, however, are political

CatoJossrn4 VoL4, No. 2(Fall 1984).CopyrightoCatoInstitute. AUrights resthed.The author Is Professor ofEconomics andDirector ofthe Center for Education and

Research In FreeEnterprise at Texas A & M University. The writing ofthis paperwasIcilitatedby grants fromtheEasbartFoundation and theTexas Educational Association.

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objectives. They give the economist something to measure, thebureaucrat something to shootat, and the ruling elite something toshout about A high rate of economic growth Is neither an indicatorof economic development nor evidence of its absence.

Empirical evidence carries a simple but true message: Capitalismhas donemore for the common man than socialism. The purpose ofthis paper is to establish the link between property rights structuresand economic development To accomplish this objective we shalllook into the incentive effects ofproperty rights in Yugoslavia on theflow of innovations. In that sense the paper departs from the generaltendency in the property rights literature to analyze the effects oflegal structures on the allocation ofresources.

Innovation and Economic DevelopmentInnovation means doing somethingthat has not been done before.

It could be the developmentof anewgood, theopening up of anewmarket, a new source of supply, or a new method of production.Innovation diverts resources from previous uses and in the processchanges the index of significance of inputs relative to output’

Operationally, innovation Is an addition to the set of opportunitychoices. It provides the community with a choice between the oldways andanewalternative. Avoluntarily accepted innovation makesthe community better off. How do we know that? Ifthe communitypreferred the old ways the innovation would have failed, as indeedmany innovations do. However, the community thatis compelled bythe state or another authority to accept innovation Is not necessarilybetter off.

Innovation refers to changes in the community’s set of choices.Moreover It internalizes those changes. A successful innovation off-sets the lawof diminishingreturns, and takes theeconomy from theold to a new equilibrium (Pejovich 1965). The effects of Innovationcould not then be analyzed within the neoclassical analyticalframework.

Innovation introduces anovelty into economiclife. Itbrings abouta qualitative change ratherthan a measurable quantitative growth intheeconomy. Toinsist on measuringthe efl~ctsofInnovation missesthe point about its true role in society. For example Martens andYoung (1979) made an attempt to provide acomparison between theflow of innovations in the Soviet Unlion and in the United States.They concentrated on the number of technical Inventions and the

‘My treatmentofInnovation and Us role In society Is Schumpeterlan,

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speed of their implementation. This kind of attempt to measureeconomicdevelopment Ignores the most relevant issue: What is thevehicle by which the community evaluates the Innovation? Techni-cal changes could mean a qualitative improvement in the commu-nity’s well-being; they couldalso mean that thecommunity is goingto be getting more of something itdoes not want Voluntary accep-tance ofInnovation enriches thecoñimunity’s welfare. It internalizesthe effectsof innovation, Thusvoluntary acceptance ofInnovation isam4or or true source of economic development

Innovation cannot be planned. Business firms and governmentscannot simply decide to havethree Innovations per month.Innova-tion is triggered by the Individual who perceives an opportunity todo something that has not been tried before, Innovation Is a conse-quence ofhis Ingenuity.tThe Innovatorhas noprevious datato counton. He faces the risk of doing somethingwhich is new—people tendto resist changes. Innovation then depends on man’s Ingenuity, hisguess aboutpeople’s preferences and incentives to acceptthe riskoffailure. Innovation is then MdividuaUstic in Its orIgIn and social InIts consequences. The bottom line Isthat thecommunity should seekand implement economic policies that promise—and that is all theycan do—to maxImize the flow of innovation.

The problem ofeconomic development boils downto a search forproperty rights structures that promise to (1) Increase thenumberofpeople whocan Innovate, (2) enhance the Individual’s incentives toinnovate, and (3) provide a mechanism for the integration of inno-vation into economic life (that is, provide for its acceptance or rejec-tion by the community).

With respect to points (1) and (2) the crucial questions aret Whocan innovate and what are the innovator’s incentives to accept therisk of failure? To be able to innovate one must have the right toacquire resources, the freedom to negotiate their uses, and sufficientincentives for the risk he tAkes. With respect to point (3) the issue isto identify the community’s judgment of the innovation’s costs andbenefits.

The right of ownershipand contractual freedom are conducive tomaximizing the flow of innovation in the community. The right ofownership is a necessary means for the dispersion of power In asociety. The right of ownership means that everyone in the com-munity is free to acquire resources. Contractual freedom replacesorders from the top with voluntary exchange in competitive markets.

~or a very telling story about the frustrations ofan Innovator In a socialist state, seeDudh,cov (196fl

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Itprovides the innovator with the ability to act in the market. Con-tractual freedom Increases the flow of information about the effectsofInnovation. It lowers the cost of the integrationof innovation andits consequences Intorelative marketprices. In this manner, freedomof contract serves as & vehicle by which the community judges,evaluates, and finallyprices thecosts andbenefits ofinnovation. Theright of ownership and contractual freedom offer Incentives to theindividual to accept the rIsk and uncertainty about the outcome ofInnovation. The gains come from the market!s acceptance of inno-vation. A successful innovation yields benefits in excessof what thebundle of resources used by the Innovator was earning before, Pos-itive profits are then created within the systemby way of theemer-gence ofnew exchangealternatives that enough people seekto exploitIn theprocess the innovator has atemporary monopoly position thatenables him to capture those gains until they are competed away byImitators. In the end the community gets the “right” amount of whatit prefers.

The right of ownership and contractual freedom are Institutionsthat are specific to capitalism. They maximIze thenumber of peoplewho could Innovate, generate incentives forpotential Innovators toacceptthe risksoffailure, assure thepotential innovator oftheabilityto actin the marketplace, and quickly integrate thecosts andbenefitsof innovation into relative market prices. These two institutIons areconceptually powerfW andperhaps necessary requirementsfor suc-cessjW economic development.

There exists a relationshipbetween property rights and economicdevelopment As property rights change, incentives to innovate andconsequently the rate ofeconomic developmentwill change as well.Let us nowlook into the incentive effects ofproperty rights in Yugo-slavia on economic development in that country.

Innovation and Economic Developmentin Yugoslavia

Most research by western scholars has traditionally emphasizedthe macroeconomic aspects of socialist economies. A predictableoutcome of this emphasis on the system of pianningand macroeco-nomic analysis has been arather poor ex ante understanding of theeconomic fOrces at work in socialist countries. Let us look at twoexamples.

In the 1950s arelatively high rate of growth of the Soviet economywas taken for granted. 0. Warren Nutter was among the very feweconomists who questioned the reported growth rate in the Soviet

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Union, doubted the ability ofthe Soviet Union to continue to growat the same rate, and denied the importance of economic growthpolicies for human wel~re.Nutter based his observations and pre-dictions on the standard price theory adjusted to take into consider-ation the incentive effects ofproperty rights. Nutter was castigatedfordefring the traditional wisdom.Yet history hasvalidated Nutter’spredictions about the Soviet economy (see Nutter 1983).

The 1965 economic reform in Yugoslavia was acclaImed as a majorstep in the dIrectionof greater efficiency. The reform was supposedto transfer decision-making powers from the bureaucracy to theemployees ofbusiness firms. Horvat claimedthat“self-managementaccelerated growth of output, and technical progress beyond any-thIng known before” (see Bajt 1983). Vanek thought that self.man-agement should be tried everywhere, andsome German economistslinked the idea of codetermination with theYugoslav system ofself-management

In the late 1960s aproperty rights micro-modelwas developed thatsuggested the 1965 reform would generate inflation, low savings,highunemployment, andserious liquidity problems (Furuboth andPejovich 1974). Moreover it suggested that those problems in Yugo-slavIa are generated by the labor-participatory system itself. Eachandevery one ofthesepredictionshas turned out to be correct

The point Is that price theory has one advantage over the analysisofaggregate variables: It is capable ofcontributing to knowledge. Inthe field of comparative studies, the price theory adjusted for theeffects ofvarious property rights has led to a simple general conclu-sion: There can be no efficient markets without private propertyrights (Nutter 1968). ThIs paper argues that there can also be noeconomic development without private ownership.

Major institutional features of the Yugoslav economic system are(1)the state ownershipofcapital goods, (2) theemployees’ownershipofthe returns from capital goods held by thefinn, (3)the employees’right to govern the finn, (4) the system ofquasi-voluntary contractsbetween firms, institutions, andvarious agencies,and (5) the substi-tution of bankcredit for the system ofadmInistrative distributionofinvestable funds. When thisInstitutional framework istranslated intothebundle ofrights that definesownership in the firm in Yugoslavia,the following picture emerges:

• The employees ownthe resIdual.

• The employees have the right to fire and hire the firm’s manage-

ment, including the director.

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The employees can neither sell the rights specified above norcontinue to ei~oythem when they leave the employ ofthefirm.

The right to capture the residual in Yugoslavia is contingent on theassociation ofone’s live laborwith thefirm’s physical assets.3 Whenthis association ceases to exist, one’s right to capture the residualceases as well,

The analysis ofthe relationship between the self-managed econ-omyofYugoslavia andeconomic development requires that we assessthe effects ofproperty rights structures onthe flow ofinnovation Inthat country. In accordance with our discussion above, the threefollowing questions are raised: First, who can innovate in Yugo-slavia; that is, who is in the position to acquire resources and deter-mine their uses? Second, what incentives does the potential inno-vatorhave to accept the risk and uncertainty associated with inno-vation? Third, how and to what extent does the innovation have topassthe market test?

Who Can Innovate in YugoslaviaThe legal rules limit the rightofownership in Yugoslavia to afew

specific assets. Those rules constrain the ability ofindividuals whoare not employed by business firms to acquire and use resources.The set ofpeople who can innovate in Yugoslavia, for all practicalpurposes, is reduced to theworkingcollective. Some limitations existwithin the collective as well. Individual employees cannot acquireand use resources, only the collective can. That Is, no individualemployee is in the position to translate his perception into actualoutcome. He has to sellhis Idea to theworkers’ council, which is thehighest governing body in the Yugoslav firm. The firm’s director Isperhaps the only individual who can use resources to implementnew ideas. Howevereven the director must seekthe workers’ coun-cil’s approval for anymajor change In the firm’s scale ofoperations(Pejovich 1973). By law the workers’ council must include skilledworkers, semiskilled workers, as well as blue-collar workers. Thusthe workers’ council Is a group ofpeople with totally diverse inter-ests, differentphilosophical backgrounds, unequal technicalknowl-edge, and dlfl~rentage distribution. Their understanding of a newventure, ability to comprehend Its consequences, and judgment ofexpected benefits cannot be the same. Moreover the attitude ofthemembers ofthe workers’ council toward the risk Is likely to differfrom one memberofthecouncil to another. Compared to the regime

‘This isa constitutional requirement inYugoslavia.

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of private property rights, the prevailing property relations InYugo-slaviamust be expected to impede the flowofInnovation Inthefinn.

Incentives to Innovate in YugoslaviaThe employees’ right to capture the firm’s earnings links the col-

lective’s decisions on theone hand and wagesreceived bymembersofthe collective on the other. The relationship between the collec-tive’s decisions and the workers’ earnings is likely to be stronger insmall firms. As thenumber ofthe employees increases, their percep-tion of the relationship between their individual efforts and theirInputs into decision-making processes on the one hand and take-home wages on the other tends to weaken. A worker who comes upwith an idea that potentially may turn out to be a successful Innova-tion will capture only a small fraction of the total gain from hisInnovation. The larger the size ofthe labor force, the smallerwillbethe Incentive ofthe worker to make an eflbrt to perceive new ideasand to sell them to the collective.

The system ofproperty rIghts in Yugoslavia reduces the director’sincentives to innovate as well.A successful innovation in Yugoslaviadoes not reward the manager as quickly and surely as it does in theWest. A successful Innovation in the West affects the price of thefirm’s stock and Increases the manager’s income because his jobopportunities are now enhanced. It is much costlier to generate thiskind of information about managers’ performance In the marketswithout private ownership rights.

To understand the link between one’s effort and his earnings inYugoslavia,we shall look attwo examples: professionalathletes (smallgroup) and the employees ofthe firm(large group).

Monetarycompensation isa powerful and perhaps necessaryvehi-cle for extractinga greater effort fromprofessional athletes. Differentmethods ofrewarding athletes in team-oriented sports stimulate dif-ferent behavioral responses from individual players.The basicmeth-ods ofcompensation are: fixed payments and performance-orientedpayments. The majordifferencebetween these twomethods ofcom-pensation lies in the allocation ofrisk. Athletes’ incomes are almostalways a mixoffixed andperformance-oriented payments. However,the relative importanceof these two types ofpayments in their totalcompensation differs from onesport to another and from one countryto another.

Fixed contractual salaries provide incentives for athletes to per-form well as individuals, to concentrate on their own performances.The athlete’s future marketability depends on his own performancein the field.The athletehas less incentive to monitortheperformance

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ofhis teammates, to extol themto a greater eflbrt, and to subordInatehis individualactions to the team’s interest It is not argued here thatathletes feel no desire for the team to win. The point is that fixedcontractual payments shift Incentive structures away fromjoint effortbythe teamand towardIndividual perfonnanées. However,the methodofcompensation based on fixed contractual income provides incen-tives for the dub to incur the costof monitoring its players and ofchanneling their performance in the direction ofjoint effortby theteam. A testable consequence ofthis method ofcompensation wouldbe a relatively largercoachIng staff

Whenathletes’ compensation Isperfonnance-orlented, an individ-ual player has incentives to contribute to the team’s joint effort, tomonitor the performance of his teammates, and to subordinate hisindividual performance to the team’s interest A predictable conse-quence ofthe performance-orientedmethod ofcompensation is thenarelativelysmaller coaching staff incentives to Invest in monitoringactivity shifts here toward the players themselves.

The method ofpayments to professIonal athletes in Yugoslavia isconsistent with theprinciple ofsel$.management—it is performance-oriented.An example discussed inthispaper is thepaymentscheduleused byPartizan, a leading Yugoslav soccer team. Information is for1911. Earnings are expressed in dollars.

In 1917 the players received fixedmonthly compensation from theclub. Compensation rangedfrom $305 per month to $174 per month.For a professional athlete this scale is not very Impressive. In thesameyearthe averagewage In Yugoslaviawas about $230 permonth.However, the players’ income depended on the team’s success Inseveral different types ofcompetition. The most Important and cer-tainly the longest (34 games) Is the Yugoslav national soccerchampionship.

The players’ compensationfor participating in the Yugoslav nationalchampionship is based onthe team’sperformance perunit Oneunitconsists offourchampionship games. Winninga gameIs counted astwo points, a tie as one point, and a loss as zero points. That Is, theteam might have been credited by zero to eight points per unit offour games. The players were rewarded as follows:

Number ofPoints CompensationO-3points $0

4polnts $192S points $6136 points $1,0137 points $1,3808 points $1,687

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These rewards were received byall individual players regardlessoftheir fixed monthly pay. Assumingthatthe team playedfour gamesper month, the difference in players’ monthly earnings betweenwinning 50 percent and 15 percent oftheir monthly games is quitestartling.

IfPartlzan lost all four games, the lowest player’s income in thatmonth would be $174, or 75 percent ofthe Yugoslav average. But Iftheteam won two outoffourgames,his monthly income would havebeen $366, or 159 percent ofthe national average. If Partizan wonthree games and lost one, the lowest player’s Income during thatmonth would have been $1,247, or about 5.4 times above the Yugo-slav average. IncIdentally Partizan won theYugoslav nationalchain-pioship in 1977 and each player received an additional bonus of$6,600.

The performance-oriented incentives are not so clearly visible inlargerfirms. Ourdiscussion here is basedonTable 1, whIch providesa concrete example of the Yugoslav firm (Pejovich 1980). Theaccounting period Is from January 1,1918 to June 30, 1918.

Several Items In Table 1 requIre special comment becauseof theireffects on the relationship betweenthe property right structures InYugoslavia and incentives.

Dohodak (value-added) is equal to the firm’s total revenue lessproduction expenses and depreciation. It Is the most Important cat-egory in the Yugoslav systemof labor self-management The workingcollective has incentives to minimize production expenses becausethere exists apositive relationship between theworkers’ presentandfuture incomes ontheone hand andthe size ofdohodakontheother.The republic and local government also have incentives to monitorexpenses incurredby enterprises. Their tax revenues depend onthesize ofdohodak. An Interesting feature of the Yugoslavtax systemIsthat only custom duties and turnover taxes are paid into the federalbudget

The government closely monitors the financial transactions ofYugoslav firms. The watchdog is the Office for Social Bookkeeping.Yugoslav firms can make payments to others neither dlrectiy northrough banks. Financial transactions must first be cleared throughthe Office for Social Bookkeeping. In fact It is the Office for SocialBookkeeping which instructs banks to make payments on behalf ofenterprises. The Office for SocIal Bookkeeping Is primarily con-cerned with the legality of payments rather than their business jus-tifications. At the sametimethe directorofthefirm, themanagementgroup, and other Influential members ofthe collective (for example,the chairman of the workers’ council), can increase their total

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TABLE 1DISTRIBUTION OF Torn REVENUE OF

THE Yucosi.4w FntM (In Dollars)

Total Revenue 21,405,912Production Expenses —18,725,928

Cost of goods 17,142,172Business expenses 1,521,680Bad debts 6,158Inventory adjustments 21,844Legal costs and penalties 1,191

Depreciation —91,166Value-Added (Dohodak) 2,588,139FIxed Legal Obligations -44,595

Insurancepremiums 28,421Disability compensation 1,123Land tax 10,441Entertainment and gift tax 2,444Solidarity fund (to alleviate 2,166

damage caused by floods, andother disasters)

Variable Legal Payments —310,181(dependenton the sIze ofdohodak)

Republic tax(7%) 89,473Education tax (5,5%) 69,604Tax for science (0.69%) 8,132Retirement &disabil. insur. (1.26%) 91,818Tax for child protection (1.81%) 22,906Health Insurance (0.68%) 8,605Building hind (1.5%) 18,983

Contractual Obligations -458,230AdminIstration costs 130,055Interestandbank charges 309,701Trade association dues 10,869Civil defense 5,308Legal costs 1,191 _______

ResIdual (Enterprise Net Income) 1.775.372Allocation to Business Fund 698,701

Allocation to Collective Consumption Fund 151,194Allocation to Reserve Fund 64,709Allocation to Wage Fund 860,168

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THE INCENTIVE TO INNOVATE

Taxes for Wage Fund (32%) 273,107County tax (1.41%) 12,128Social protection tax (0.52%) 4,472Education tax (8.11%) 69,760Culture tax (0.77%) 6,624Physical education tax (0.16%) 1,316Childprotection tax (0.88%) 7,569Employmentagency tax (0.24%) 2,065Retirement& disability tax (5.91%) 51,352Health tax (7.89%) 67,867Other taxes (5.8%) 49,888

Net Wage Fund 587~061Average Monthly Wage (330 employees) 296SOURCE: Contemporary Pnwtice(SavremenaPraksa), Belgrade: SDK(SocialAccounting Service), 1978, p. 703.

compensation by way of the consumption of nonpecunlary goodssuch as frequentbusiness trips, sponsorship of conferences, use ofcompanycars, andbanquets forbusiness associates.While incentivesto minimize production expenses exist in Yugoslavia, the positivecosts ofmonitoring the director and his associates suggest that someunnecessary expenditures can be presumed.

Taxable dohodak is different from the firm’s total dohodak. Tocalculate theplant’s taxabledohodak, which in ourcase is $41,265,542,adjustments are made in the finn’s actual dohodak of$2,588,378. Thefirm is allowed to subtract from its dohodak the amount equal to theemployees’ guaranteed income. A worker’s guaranteed monthlyincome is 55 percent of the last year’s average personal income Inthe county where the firm Is located. Clearly, guaranteed monthlyincome varies from one locality to another and from one year toanother. Other deductible expenses include contribution to theadministrative costof the firm, loans that the firm must make for thedevelopment of less-developed areas of the country, interest pay-ments and other bank charges, insurance premiums, membershipdues, contributions to the building fund, and subsidized meals forworkers.

Taxes that are paid from the finn’s dohodalç wIth one exception(the republic tax), are paid into the budgets of self-managing com-munities of interest. The institution called the self-managing com-munity ofinterest has Important bearings on the relationshipbetweenproperty rights and incentives in Yugoslavia. The provision ofmanyservices, such as welfare, health, education and retirement, isnegotiated contractually by organizations that represent those who

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supply specific services and organizations that representthose whodemand them. They form self-managed organizations governing aregion. Forexample, in thefieldofhealth, aself-managedagreementon the formation ofa self.managed community of interest is madebetween self.managlng organizations and other institutions repre-senting those who are eligIbleby law to receive health services onthe one hand and self-managing organizations which provide thoseservices on the other (hospitals, clinics, medical institutes, phanna-des,and soon). Territorial boundaries ofthe regions aredetenninedby such factors as the economic conditions oflife in the area, homo-geneity ofthe population, the area’s geography and the availabilityofhealth services. The law specifies the minimum provision ofser-vices that must be provided by the seW~managlngcommunities ofinterest. However, contractual partners are free to negotiate the pro-vision ofaddItional services. They also negotiate the costof servicesand determine taxes that would raise the requiredrevenue. Itmeansthat taxes couldvary from one region to another as well as from oneyear to another. Importantly, education, health protection, retire-ment, and otherpublIc services in Yugoslavia arenotprovided throughstatebudgets.Taxes for theseservices are notpaid into statebudgets.

The residual belongs to the collective. According to Yugoslav law,theresidual must be allocated among the business fund, the collec-tive consumption Rind, the reserve Rind, and the wage fund. Theworkers’ council determines the allocation ofthe resIdual amongallthese hinds, as well as the distribution ofthe wage hind among theIndividual employees. However, the workers’ council must publiclyannounce its distributional criteria well in advance or have themapproved by the collective at the general meeting. In deciding theschemeforthe distributionofthe firm’s residual,theworkers’ councilIs expected to adhere to distributional guidelines stated in self-management agreements that are explained below.

The distribution of the wage hind among the firm’s employees isusuallyregulatedinthefollowing way: Theworkers’ councilattachesa certain number ofpoints to each position in the firm. The criteriaused to determine the numberofpoints for each Job usually includeskill required, education, health risk, hardship, working conditions,and the lIke. Those are general criteria used in Yugoslavia, but therelative importance differs from one firm to another. In addition self-management agreements provide general guidelines for individualworkers’ councils. The firm’s wage Rind after taxes is divided by thetotal numberofpoints. The value ofa point is thenmultiplied by thenumber of points associated with each job, and the result is theemployee’s take-home income for that accounting period.

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ThE INCEWnn TO INNOVATE

Incentives to innovate clearly exist in the firm, but they are notstrong enough to offset risk and effort Suppose the manager is paidfive times the average monthly wage; that is, $1,480. In acceptingthe risk and eflbrtof innovatIngand raising the firm’s dohodak by 10percent, or $43,145, the manager will add only about $148 to hissalary. And the absenceoffinancial marketswill impede his chancesofcapturing even thosemeagergains in the form ofhIgher income.

Taxes paid from the wage fund areprimarily paid into thebudgetsof local political units and self-managIng communIties of interestThese taxes vary from one region to another and their uses are spec-ified. As was pointed out earlier, the Yugoslav tax system relates thebenefits of various public activities financed through taxes to theircosts. There is a relationship between the cost of public servicesprovided in Yugoslavia at the local level and the costs borne by thecollective. This fact provides Incentives for the collective to try toargue for benefits that are commensurate with costs. It also providesincentives for those who offer public services to seek cost-reducinginnovations.

The Integration ofInnovations Into Social EconomyThe market for consumer goods and the system of contractual

agreements assure members ofthecommunIty that those innovationsthat are beneficial to It will eventually be incorporated into sociallife. Such an assurance does not exist in other socIalist states. Whilethe market for consumer goods in Yugoslavia works the way com-petitive markets work elsewhere, the system ofcontractual agree-ments is aunique phenomenon. The employees in theYugoslav firmareconsideredto be contractual partners in the teamdecision-makingprocesses. Plantswithin each firmnegotiate written contracts amongthemselves. These contracts specify theirmutual rIghts and obliga-tions. Institutions and firms in related activities negotiate contractsthat specify the pooling ofresources, criteria for the distribution ofincome, and other business matters. These contractsare called self-management agreements (samoupravnl sporazumi). Groups boundtogether through broad common interests, such as finns, trade asso-ciations, labor unions,Institutes, and governmentbureaus, negotiatethe so-called social contracts (dnsstvenl ugovori) that specify theirmutual rights and obligations. Provision of welfare, health, educa-tion, and other services, as we have already noted, is negotiatedbetween those who demand social services and those who supplythem. In this mannercontractual agreements encompass the entiresocial and economic life in Yugoslavia.

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Contractual agreements are not voluntary. They are mandated bylaw and the basic terms are frequently stipulated in advance (forexample, the minimum health care). However, within these con-straints, the terms of contracts are freely negotiated among the par-ticipants. Mi Immediate consequence ofthe Yugoslav system ofcon-tracts is to reduce the role ofthe state in regulating and controlingeconomic life. The difference between contracts in Yugoslavia andcontracts, say, In the United States is with respect to the role ofconsIderation. In the United States the courts are not supposed tolook into the adequacy ofconsideration, only its existence. The pre-sumption is that the parties involved know better (than the judge)their preferences and the relative values of things that are beingexchanged. In Yugoslavia the adequacy ofconsideration is controledby the state. This implies some price controls and the consequentallocation effects. However, adynamic,and perhaps themost impor-tan~consequence ofthe system ofcontractual agreements in Yugo-slavia is that it creates incentives for the participants to seek evergreater freedom for themselves in negotiating the terms of contrac-tual agreements.

State Ownership ofCapital Goods, Restrictions onContractual Freedom, and Economic Developmentin Yugoslavia

The state ownership of capital goods precludes thecapitalizationof the future benefits of a successful Innovation Into theirpresentmarket value. The employees of theYugoslav finnare free to exchangetheir current consumption for higher future income by leavinga partof the firm’s earnings for investment in new ideas. Yet they canneither sell their claIms to future earnings in future investmentsmadebythe firmduringtheperiodoftheir employmentnor continueto receive their share of those earnings once they leave the employof that firm. It follows that the employees capture the benefits frominnovation in the form of higher wages. When a worker leaves thefirm, he loses all hisclaims to the future returns despite thefact thathisearlier sacrifice ofcurrent income (thatIs, his share ofinvestment)helped the firmto finance innovation. Given the cost of innovation,the relationship between the worker’s time horizon (that is, theworker’s expected employment by the firm) and the period of timeoverwhich thebenefits of a successful innovation are to be receivedbecomes important Incentives to innovate will tend to fall as theworker’s time horizon gets shorter relative to the expected life ofinnovation.

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ThE INCENTIVE TO INNOVATE

The nontransferability of the worker’s right of ownership in thefirm’s earnings means that prevailing property rights structures inYugoslavia provide no room for diversification in risk bearing amongindividual workers whose risk aversion is not likely to be the same.’Thus the employees of the Yugoslav firm must have incentives toseek those Investmentventures and to preferthose innovations whoseoutcome is to shift income forward and postpone cost That is, theYugoslav economic system provides Incentives for the collective toseek innovations that maximize the near-term cash flow.

A constitutional requirement in Yugoslavia, which stems directlyfrom the Ideology that gave birth to the state ownership of capitalgoods, 11 that “live labor must be combined with capital goods inorder to receive the residual,” The late Edward Kardelj, a leadingYugoslav theoretician and party leader, wrote (1981, p. 147);

The social andhistorical substance of self-management lies in theemergence of afbrm of production relations based on state owner-ship ofcapital. . . . The workerappropriates on the basis ofhisworkdirectly, free from all forms of wage labor relations.

A consequence of the requirement that the returns from capitalassets belong to workers who use them is to reduceopportunities forthe members ofthe collective to seek entrepreneurial gains outsidetheir firm. Some years ago this point was recognized by B~t(1968,p. 3);

Ifone wants todevelop Innovating activity In socialist enterprises,one has to provide enterprises with adequate legal rights In orderto exchange factors and products In as free amanner as possible.

I would not be surprised, therefi,rn, Ifsomewhere In the futurethis will find its expression In giving enterprises property rights Intheir means of production.

In the late 1960s the Yugoslav firm was free to determine theallocation ofits net earnings between the wage fund andother funds.The share ofthe wage fund In the firm’s net earnings rose from 60percentIn 1964 to over80 percent in 1970,The Yugoslav governmentwas looking for a dlfl~rentoutcome. The govetnment wantedbusiness firms to increase the share oftheir earnings allocated forInvestment purposes. The Yugoslav leaders clearly misread incen-tives inherent in the prevailing property right structures in that

0n the general pointthat lack ofprivate property rights precludes risk diversification,

see Jensen andMechllng (1979).

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country. The 1965 reform created incentives for one type ofbehaviorwhile the state expected differentbehavior.

In the early lObs the government decided to Interfere with theallocation ofresources withIn the firmand to lower the ratio ofwagesto retained earnings. The government also decided to refrain fromreintroducing direct adminIstrative controls. As we have seen, thevehicles used by the government were to enlarge the role of con-tractual agreements and to Impose constraints on their terms. Thelaw required firms, institutions,and other economic organizations tonegotiatesocial contracts stipulating, amongother things, thecriteriafor allocating enterprises’ net Income. The government reserved foritself, so to speak, the right to assess the adequacy ofconsideration.

In order to examine the efl~ctsof governmental controls in Yugo-slavia on Incentives to innovate, let us consider the 1982 socIal con-tract for the city ofBelgrade and compare it with the social contractfor 1972.’ The social contract stipulates rules for the allocation ofenterprises’ net income between the wage fund and retained earn-ings.6 The crucial variable Is the ratio ofnet income or earnings (E)to adjusted labor (L); that Is, E/L.

The term “adjusted labor” refers to a labor-force figure adjustedfor differences in skilland education levels, which varyamongfirms.The approach used in Belgrade in 1972 and 1982 was to attach acoefficient to each level of skill and education. The adjusted laborforce was then obtained for each finnby multiplying the number ofemployees in eachcategorybytherelevant coefficients and summingthe products. Thecoefficients used in 1972 and 1982 were as follows:1.00 foran unskIlledworker; 1.20for a semiskilledworkeror aworkerwith less than ahigh school education; 1.70 for aqualified worker ora worker with a high school education; 2.20 for a highly qualifiedworker; 3.00 for aworker with acollege education;3.30 for a workerwith a master’s degree; and 3.80 for a worker with adoctorate.

After determining all theenterprises’ labor-adjusted earnings, theE/L ratios are stated in terms of Index numbers, with the averageearnings per adjusted labor set equal to 100. The social contractsthen stipulate the share of earnings that must be retained (R/E) ateach dIfferentE/L ratio. Since the share ofearnings going to thewagefund (W/E) and the share of earnings retained (WE) mustsum to 100,W/E is determinate. The productof the E/Land W/E ratios gives us

‘See the Collection ofRegtdasIoss (1982).‘Earnings are retained for allocation to the business fund, the collective consumptionhind, and the reserve hind. Hereafter we shall simply rotor to these hinds as the“Internal hinds’ or retainedearnings.

442

THE INCENTWE TO INNOVATE

theratioofwagesper adjusted labor(W/L) at each differentE/L ratio.These ratios are presented In Table 2, which shows the allocation ofnet income or earnings in Belgrade enterprises under the socialcontracts In 1972 and 1982.

The data In Table 2 can be used to help uncover the system ofrewardsimplicit In the 1982 social contract forBelgrade and to makecomparisonswith the incentive structure in 1972. Figure 1 plots theallowablewage perworker (W/L) against earningsper worker (E/L),andshows thatgreater earnings bythe firm yield only modestgainsto workers in terms of current rewards. For example, in 1982 Ifearnings per worker doubled from 100 to 200, the wage per workerwould have increased from 78 to 108, or only by 38 percent Thecurve relating W/L to E/L moves furtherand further away from the45°line (the maximum reward line) as earnings per worker areIncreased. From the pointofview ofthe collective, this mandatedreward system, which constrains the allocation ofearnings betweenthe wage fund and retained earnings, is Inefficient The fect that thestate needs social contracts in order to increase the share of retainedearnings is thebest evidence that workers would prefer to allocate alarger share of the firm’s earnings to the wage fund. Thus socialcontracts forbothyears penalizeworkers in an efficient firm for theireflbrts toward stillgreater efficiency.

Whatcan we say about the effects ofsocial contracts on Incentivesto innovate? Innovation isarisky ventureanda successful innovationyields largebenefits, In fitct thebenefitsmustbe largeandcapturableto alleviate the risk. FIgure 1 tells us that the larger the expectedbenefits from Innovation, the greater Is the distortion from the 45°line. Since thebenefitsexpected from retainedearnings (thatIs, fromInvestment) are not transferable in Yugoslavia and can be capturedonly while aworker remains employed byhis firm (the time horizonproblem), the 1972 and 1982 social contracts can be said to havereducedthecollective’s incentives to take risksassociated with inno-vation. Moreover Figure 1 suggests that the Incentives to innovatehavebeen reducedbetween1972 and 1982. In comparison with 1972,the 1982 social contract clearly reduces the collective’s incentives toseek risky ventures.

ConclusionWe can summarize our discussion on the relationship between

property rights in Yugoslavia and incentives to innovate as follows.Flrst~the employees’ right to govern the firm transfers the rightto acquire and use resources needed for Innovation from the

443

TABLE 2SOcIAL CONTRAcT FOR BELGRADE ENTERPRISES,

1972 ~m 1982

IIEarningsper

Adjusted Labor(E/L)

InternalAllocationto

Funds(WE)

Allocation toWage Fund

(W/E)

Allowable WageperWorker

(W/t)1972 1982 1972 1982 1972 1982

260 53 57 41 43 122 112250 52 55 48 45 120 112240 51 54 49 46 118 110230 49 52 51 48 117 110220 48 50 52 50 114 110210 45 48 55 52 115 109200 44 46 56 54 112 108190 43 43 57 57 108 108180 42 40 58 60 104 108170 41 37 59 63 100 107160 40 33 60 67 96 107150 38 29 62 71 93 104140 31 28 63 72 88 101130 35 21 65 13 84 95120 33 25 67 75 80 90110 30 24 10 76 77 84100 27 22 13 78 73 7890 23 20 78 80 69 7280 19 15 81 85 65 6870 13 11 81 89 61 6260 5 5 95 95 57 57

THE INCENTIVE TO INNOVATE

W/L

180

160

140

120

100

80

60

40

20

FiGURE 1EFna OF SOCIAL CONTRAcTS ON THE ALLOCATION

or Mn INCOME

bureaucracy to the working cooperative. Therein lies the m~ordif.ference between the Soviet economy and the Yugoslav economy.Second, theemployees’right toappropriate the firm’searnings estab-lishes a link between the outcome of innovation and theemployees’welfare. Third, the market for consumer goods and the system forcontractual agreements assures the community that the role ofbureaucracy In compelling the community to accept Innovation isreduced.

As we look at the relationship between the property rights struc-tures in Yugoslavia and incentives to Innovate, we must concludethat In comparison with other socialist states in the East, the incen-tives to innovate In Yugoslavia are significantly greater. However,with respect to the capitalist West, they are significantly smaller.Only members ofthe working collective can innovate In Yugoslavia.Within theworking collective, decisions to Innovate must be approvedby the collective as a whole. The link between innovation and Itseconomic benefits are not as strong as they are in the West.

The process of Integrating innovation into the social system inYugoslaviadiffers from other socialist states. In the East, innovation

E/L~W&

19721982

20 60 100 140 180 220 260 E/L

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is integrated Into social iS via either approval by the ruling eliteorinfermal managerial practices (Furubotn and Pejovich 1974). InYugoslavia therole of bureaucracyIs still there, butit Is diminished.The m~orfactor thatcontrols the Integration ofInnovation into sociallife is its acceptance by the community via the market fbi consumergoods and various types of contractualagreements. The integrationof successfId Innovation into social life also differs between Yugo-slaviaandthe West The right ofownership andcontractual freedomIn the Westprovide a low-costvehicle forspeedy integrationof thecostandbeneflts ofinnovationintorelativeprice structures. InYugo-slavia the terms of contractual agreements are far from beIng freelynegotiated. There are also price controls In themarket fbi consumergoods. Thus the integration of suècessful Innovation into the sociallife cannot be expected to be quick and accomplished atas low acostas In theWest

ReferencesBsJt, Aleksander. ‘the Economic Growth of Yugoslavia.” Paper presented

at CESES Conference, Florence, Italy, 1983.B~jt,Aleksander. “Property inCapitaland the Means ofProduction In Social-

1st Economies.”Jotsrnal ofLaw and EconomIc. 11 (AprIl 1968): 1-4.Collection of Reguiatlons. See ZblrkaProplsa.Dudlncev, VladImir D. Not by Bread/done. New York: E. P. Dutton & Co.,

1951.Furubotn, Elrllc, and Pejovich, Svetozar, eds. The Economics of Property

Rights. Cambridge, Mass.: BallingerPublishing Co., 1914 chap. 14.Jensen, Michael C., andMeckling,William H. “RIghts and Production Func-

tions.”Jounwi ofBusiness 52 (October 1979): 469—506.Kardelj, Edvard. “Integration of Labor into a Society of Self-Management”

In his SocialismIn Theory and PractIce,pp. 55-201.Belgrade: Bad, 1981.Martens, John, andYoung, John. “Soviet Implementation ofDomestic Inter-

ventions7 In Soviet Economy In a Time of Change, pp. 472-510. JoIntEconomic Committee of the U.S. Congress. Washington, D.C.: Govern-ment Printing Office,October 1979.

Nutter, C. Warren. ‘MarketsWithout Property: ACrand Illusion.” In Money,the Market and the State, pp. 137-45. EdIted by Nicholas Beadles and L.Aubrey Drewry, Jr. Athens, Ca: University of GeorgiaPress, 1968.

Nutter,C. Warren.Political Economy and Freedom. Indianapolis, md.: Lib-erty Press, 1983.

Pejovich, Svetozar. Market-Planned Economy of Yugoslavia. Minneapolis:University ofMinnesota Press, 1965.

Pejovich, Svetozar. “The Banking System and the Investment Behavior ofthe Yugoslav Firm.” In Plan and Market, pp. 285-312. EdIted by MorrisBornsteln. New Haven: Yale University Press, 1973,

Pejovich, Svetozar. “Innovation and Alternative Property Bights.” In Inno-vatlons-Probleme In Ott undWest,pp. 41-9. EdIted by Adolph Schuller.Stuttgart: C. F. Verlag, 1983.

Zblrka Pnplsa. Belgrade: SluzbaDrustvenogKejigovodstva (Social AccountingService), 1982.

446

“THE INCENTIVE TO INNOVATEUNDER ALTERNATIVE PROPERTY

RIGHTS”: A COMMENTDeborah DuffMilenkovitch

I am in broad agreement with Pejovich’s description of propertyrights In Yugoslavia. He has defined a complex system of propertyrights very clearly and has established beyond any doubt that theproperty rights are such as to provideastronger relationshipbetweenenterprise earnings and Individual earnIngs than is true In conven-tional socialism, andaweakerone than is true in capitalism (Pejovich1984). Thus the system of workers’ management is an intermediatestage In the property rights continuum. He has also clearly poIntedto the greater role of the market mechanism in Yugoslavia and itsimportance in providinggreater opportunities for socialvalidation ofresource allocation decisions,asocial validation that is lacking in thesocialist countries of Eastern Europe.

Pejovich evaluates these conclusions about Yugoslavia’s propertyrights In a framework In which the existence of full property rightsby individuals and full social validation of innovation through themarket mechanism becomes theonly standard by whichto evaluateaproperty rights system. This approach has two limitations. First~inorder to establish the correspondence between hill rights ofowner-ship and freedom of contract and social well-being, Pejovich mustmake some additional (unstated) assumptions about the effects ofchanges in property rights on the performance of the system. I shalltry to identlfr these assumptions and their role in his conclusions.Second, in arguing for the superiority ofa system on the grounds oflogic, he departs from his own standards ofsocial evaluation by thechoices ofthe individuals faced with these alternative systems; hisargument therebybecomes inconsistent By Identlfring these unstatedassumptions and logical inconsistencies, and removing them from

CatoJouma4VoL & Nth2(Fall 1984).Copyright C CatoInstitute, All rlgbts reserved.The author Is Profrssor of Economics at BarnardCollege.

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the argument, we can better see whatwe really know, and where toadvance our knowledge about the Impact of property rights on thewelfare ofthe common man.

Pejovich’s Argument about Innovationand Property Rights

Pejovich discusses the effect ofthe system of property rights onthe Incentive to innovate. He uses the concept of innovation in itsSchumpeterian sense. The entrepreneur ceaselessly scans thehori-zon searching for new opportunities, either new ways to produce ornew products to produce. The entrepreneur is motivated by theprospect of the short-term gain from being the first to see andtry anewIdea; inthe longrun theprofitswillbe erodedas others duplicatehis activity. Thus It is the entrepreneur who brings new methodsInto production; and It Is the process ofcreative destruction oftheold and the successful imitation of the new that propels societyforward.

The elements ofPejovich’s argumentcan be listedas follows:1, Innovation means an addition to the set ofopportunity choices.2. The community faces a choice between the old way and the

new alternative.3. A voluntarily accepted innovation makes the community

better off.4. The property rights structure influences (a) thenumber of peo-

ple whocan Innovate; (b) the incentives for individuals to inte-grate; and (c) the mechanism far acceptance or rejection oftheInnovation by the community.

5. The rightofownership means that everyone in the communityis free to acquire resources for the purpose of Innovation. Theright ofownership offers Incentives to the Individual to acceptrisk and uncertainty. Contractual freedom means that Individ-uals are free to maketheir own choicesin accordance with theirown prefarences. Contractual freedom serves as a vehicle bywhich thecommunityaccepts or rejects the innovation resultingfrom entrepreneurial activity (social validation).

6. When the right ofownership is combined with contractualfree-dom, we have the characteristicproperty rights ofcapitalism.’

‘The notion of ownorship involves a number ofdifferentrights whichIn capitalismarebundled together (Pejovlch 1068; Milenkovltch 1911); (a) Theright touse property forpersonal production and consumption; (b) the right to use property personally formarketproduction andto sell the produceandretain the proceeds; (a) the right to rentproperty to others and to receive Income therefrom; Cd) the right to keep property

448

COMMENT ON PEJOvICH

7. These rights are necessary for optimal innovation. The right ofownership and contractual freedom maximize the number ofpeople who can Innovate, generate optimal incentives forpotential innovators to accept the risks of thilure, and mostefficiently provide lbr social evaluation ofthe innovation throughthe market mechanism.

Umitations ofthe ArgumentThe argument seems logically convincing. Acomparison ofLan-

gean market socialism, worker-managed market socialism, andcom-petitive capitalism (underconditions ofsel&lnterestedbehaviorandrisk bearing) shows that given certain assumptions, no system canperformbetter thancompetitive capitalism(Milenkovitch 1983). Fur-ther, only systems with Institutions thatmImic capitalist Institutionscan emulate competitive capitalism’s superior entrepreneurialperformance.

This conclusion is reached bycomparing thebehaviorofthe alter-native system of property rights with the behaviorofthecompetitivecapitalist system. The conclusion rests on the validity ofthe com-parison; that is, on the assumption about what things remainunchanged when the systemofpropertytights changes. Letus explorewhat things besides the incentive to take risks for expected returnsand social valuation of the results through the market mechanismmight change as a functionof property rights.

As Pejovich notes, the incentives far shirkIng may be different inworker-managed as opposed to capitalist firms. However, he doesnot relate this observation to the question ofthe choice of techniqueacross systems. There may be systematic differences across systems,based on the need to monitor and control laborperformance, In thekinds of Innovations that pay off (Noble 1979). Thus, In a capitalistsystem, certain kinds ofinnovations could ~Il the test of the marketbecause under capitalist production relations theyhave low returnsdue to the high cost of monitoring the behavior of the workers.Therefore the techniques chosen may differ across systems. Ifwork-ers had less incentive to shirk and more incentive to monitor oneanother In an alternate property rights system, highly productive

without using 1t (e) the right to alter the nature ofproperty; (I) the right to useup ordepleteproperty; (g)theright to sell physicalproperty; (h) theright to liquidate agoingconcern;and(I) the right to sell shares ofa going concern.

When these property rights are bundled together, we have the form of ownershipcharacteristicof capitalism. Other systems—feudalism, slavery, socialism—canbe dis-tinguished by diSrent bundling ofthe property rights. When theright of ownershipIs combined with contractual freedom, we have thecharacteristic rights ofcapitalism.

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techniques, rejected under capitalism, might come into operation.As a result the production function need not be the same acrosssystems.

Pejovichassumes individual agents who maximize utility respond-Ing to the prices offered for supply offactors ofproduction and riskbearIng. Utility isa functionofIncome andindependent ofthesystemofproperty rights.Tothe extentthatotherläctors motivate the supplyofentrepreneurship—prideIn one’sownwork,valueplacedon externalrecognition not translated Intomonetary terms, altruism—outcomesmay be differentThe significance ofall threefactors mightbe greaterunder alternative property rights that are not focused solely on ban-SI returns to Individual suppliers offactors.

The workers on the production linemay have specific knowledgeabout ways to Improve the production process, due to their specificon-the-jobtraining. An individual worker may have an idea, but thecosts borne by the Individual worker of obtaining the resources toImplement his idea may be high relative to the gain borne by theindividual. Pejovich focuses on the disincentive to innovate whenthe benefits are shared inacooperative, but does not give equivalenttreatment to the possible positive Incentive to Innovate due totheshared nature ofthe start-up costs. Ifan alternate systemof propertyrights increases the likelihoodofcontributions from the workers, thatsystem may have higher gains in productivity from innovations.

The capacity to internalize externalities might differ across sys-tems, For example, there could be higher subjective levels ofsatis-faction or lowering ofstress associated with workafter an Innovationhas occurred. To the extentthat not all ofthegains ofthe Innovationare appropriable by the entrepreneur, and some of them may beappropriated by the workers, worker-managers may be better situ-ated to internalize the externalities.

Pejovich’s conclusIons have to be reconsideredunder the follow-lug conditions: (a) If the set ofusable Innovations is greater underworkers’ management; (b) ifthe Incentives to provide innovations isgreater for any given monetary reward; (c) ifthe expected productiv-ity of workers’ contributions to Innovations are greater thanthose ofcitizens at large; or (d) Ifthe possibilities of internalizing the exter-nalities are different Thus we can logically drawup a different setofassumptions about the nature of reality under alternative sets ofproperty rights. Given these alternative assumptions the propertyrights system will help determine Incentives, ability to internalIzethe externalities, location ofknowledge most likely to yieldproduc-tive Innovations, appropriabillty ofthe returns to an innovation, Impacton technological choice ofthe need to monitor, and the distribution

450

COMMENT ON PEJOVICH

ofsharedcosts and shared benefits. Such assumptions could logicallyyieldconclusions dSrent from those Pejovich reaches. To dlscrim-mate among alternative hypotheses about reality, we have to resortto some form ofmeasurementand hypothesis testing. Otherwise weare stuck within a sterile logical deduction exercise in which theassumptions, as always, contain the conclusIons.

The Relationship ofProperty Rights to DevelopmentPejovich relates his discussion of entrepreneurship to economic

development

• ‘iVioluntary acceptance ofinnovation Is a mi4or or true sourceofeconomic development” (p. 429);

• “The problem ofeconomic development boils down to a searchfor property rights structures. . .“ (p. 429);

• “This paper argues that there canalso be no economic develop-ment without private ownership”(p. 431).

This last is averystrong proposition. Does Pejovich persuade us?Partly this Is aquestion of definitions. Clearly this is not the dom-

inant way in which development Is used In economics. A processthat most economists would identlfr as economic developmentoccurswhen, In a poor, agrarian country, sufficient capital is found to extendthe availability ofbest techniques to all producers, transforming aneconomy out ofa vicious cIrcle of low productivity, low Income,lowsavings, low Investment, highfortuity,highpopulation increase,andlowper capita productivityand low Income.

Pejovichassumesglobal frictionless capital markets, so that capitalwill flow effbrtlessly to any use where the marginal rate ofreturn ishigher for equivalent risk. Capital shortage, by assumption, cannotbe a problem in Pejovich’s framework. Therefore the only barrier todevelopment is insufficient entrepreneurship due to insufficientlydeveloped Incentives In the system ofproperty rights.

Is this a useful frame ofanalysis? This seems to fly in the fhce ofmuch oftheexperience ofdeveloping countries, whichsuggests thatcapital shortage Isaproblem, perhaps theprincipal problemofdevel-opment.But is It a problem only because ofInept policies on thepartof the developing countries which have tried to restrict the flows ofcapital?

The North-South literature (Burgstaller 1983) shows, within theframework of neoclassical general equilibrium modeling and clas-sical assumptions about unlimited supplies of labor in the South,Imported capital from the North can both relatively and absolutely

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Impoverish the South. Therefore a policy on the part ofthe South ofrestricting capital flows from the North and focusing on generatingSouthern capitalcouldbe beneficial to the local welfareoftheSouth.

Further, theory shows that global factor mobility will maximizeglobal welfare throughequalizingmarginal factorproductivity.This,however,does not ensure that the groups initiallyhaving lowcapitalendowments will be better off, although they could remain equallywell off ifthe North bribed the South to accept free trade and capitalflows. In the absence ofbribery onthe partofthe North, to Improveits position the South needs to increase its stocks ofcapital, throughself-generatedsavings. The capacity to generate savings may not beIndependent ofthesystem ofpropertyrights, The“prisoners’dilemma”may operate In the savings decisions. Ifthere is an increase in thesupply of capital, this will cause an upward shift in the margInalproduct of labor function. If the supply of labor remains the same,but the demand for labor Increases as a result of the shift, the wagerate will rise. Thus a portion of the return to the Increase In thesupply of capital does not accrue to the suppliers of capital If theyare differentfrom the workers. The marginalprivate benefits to sup-pliers of capital are less than the marginal social benefit to society.If each individual supplier must make these decisions in Isolation,too little capital will be supplied. If society is homogeneous in itstime preferences, then a collective choice to supply capital wouldresult in an optimal rate of capital formation. If society is not homo-geneous In Its time preferences, then we have no way of unambig-uously rankingacollectivechoice representing thewill ofthem~or-ityover individual choices which give abetter representation to thewillof the minority, or of ranking them the other wayaround.

Local shortage of capital is a real phenomenon of development,not one to be ruled out ofexistence a prioribyassumptions thatwhatis good for the world as a whole must be beneficial to the South. Ifthe shortage of capital Is real, then useful discussion of economicdevelopmentand property rights will give attention to the impactofproperty rights on increasing the local supply of capital, and notjustto entrepreneurship.

The Difficult Case for Property Rights: JapanClearly, by any definition, Japan has experienced substantial suc-

cessful Innovation In the post—World WarII period. More important,Japan’s economic system defies any simple location of Identifiableproperty rights for several reasons. First, the role ofequity capitalappears to be quite differentIn Japan. While there is private equity

452

COMMENT ON PEJOVICH

capital, thedebt/equity ratIo maybe the reverseof that in the UnitedStates, about 80/20 or 70/30. In addition much of the equity is heldbyother institutions,not Individuals, inaseries of interlocking own-erships and directorships. The suppliers of debt financing are In amore controlling position than the holders of equity capital. Further,equity capital turns over only rarely and there Is no ongoing marketon which to record the Impact on thevalue ofthe assets of differentmanagerial decIsions. Second, a large portion of the savings is pro-vided by individual citIzens through the postal savings system andprocessed through the Japan Development Bank and the FIscalInvestment and Loan Plan, which have no equity ownership butwhichconvert these funds into Investment loans. And third, am~orproperty rightdoes existin the form ofjob tenureandareward systembased on seniority and variable bonuses for the males who obtainemploymentin themajorcorporations. ItIs, however, nonmarketableandnontransferable,

According to the property rights analysis, Japan lacks classic cap-italistic property rights and should therefore be deficient In entre-preneurship. This does not appear to be the case.

Capitalism Is the Best System for the Common ManPejovich claims that capitalism has produced a standard of living

that no other system can match. However, when the argument isstated in this form, there is no way to separate the effect ofan eco-nomic system from natural endowmentsand historical circumstancesIn determining the standard of living.

His point about the necessity of differentiating between growthrates of CNPandthewell-being oftheconsumerIs an importantone.However, it Is not Immediatelyobvious how to make a comparisonof the effects of economic system upon the well-being of the con-suiner. Table 1 shows that for many intervals, the annual rates ofgrowth of percapita consumption in the USSR have exceeded thoseIn the United States.

There are, of course, problems Involvedin meaningfully measur-ing consumptionImprovements fortwo societieswhen in one ofthemconsumption Isnot composed ofthe items reflecting the preferencesof consumers. In addition,other elements matter to thecommon manbesidesconsumption. Securityof employment,the level ofthe safetynet, the opportunities for advancement, and individual freedom areall important The question ofwhich system performs better for thecommon man is therefore complex.

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TABLE 1

Ar.miua CRowni RATES OF CONSUMPTION PER CAPITA,INCLUDING COMMUNAL SERvIcEs

USSRYears Crowth Rate’

United StatesYears GrowthRate’

1928—1918 2.8 1869—1929 2.41928—1937 1.1 1929—1918 1.71950—1969 4.5 1950—1969 2.31970—1978 2.5 1970—1918 2.1

‘In percent per annum.Souacg: Gregory and Stuart (1981, p. 360).

Pejovich’s requirementof socialvalidation of “choice sets” by theIndividuals involved means,however, thattheonlywaywe can knowwhat system of property rights is preferred by the common man Isby observing his voluntary choices. Given an opportunity to voteforthe system they would prefer to live In, citizens could show us bytheir feetwhat their preferences are. Most likely manywould preferto take therisks, rewards, distributional system, freedoms,andethicalvalues associated withcapitalism, while some wouldopt forthe risks,rewards, and values ofsocialism. There Is no way we can rank onecommunity bundle as unequivocally superior inmeeting the needsof the common man than another, as long as some citizens wouldvoluntarily choose each.

ConclusionThe question at Issue—the effect of property rights on the well-

being of the commonman—is a serious one. As Pejovichhas shownIn his discussion of Yugoslavia, the set of property rights is a contin’uum, sowe need not and do not face an all-or-nothing choice.

The socialist economies of Eastern Europe have been hamperedbyinadequateIncentives forentrepreneurship, Insufficientpenaltiesfor poor choice, and the absence ofmechanisms for social valuationsof the choicesof the leadership.

The real Issues are: What costs do we pay In terms of entrepre-neurship and social validation foregone and Individual liberty lostfor establishing a system with greater ethical appeal in terms ofequality, full employmentand security, andpossiblymacroeconomicstability (ICornai 1980)? If wealth were equally distributed, In-dividuals couldjoin together freely In workingmen’s associations, asProudhon suggested over a century ago. Then we could have the

454

COMMENT ON PEJOVICH

benefits of maximally effective entrepreneurship, collaboration Inthe workplace, and social validation of resource allocation on themarket. But even Ifwe startout with equality, the consequences ofamarket mechanism under uncertainty is an income distribution thatmany findrandom, unjust~and unacceptable In its unregulated form.The issue Is not whether entrepreneurial Incentives andsocial vali-dationare desirable, butwhat is thecost. Ifwe really want to under-stand the merits of plan and market—the polar cases founded ondifferent dispersions of property rights—it seems to me that theseare thequestions we need to address.

At the theoretical level we need to be aware of the dangers ofallowing untested and unstated assumptions to enter and to invali-date our arguments about the relationship between property rightsandperformance. Wemust eschewreachingconclusionsabout socialrankingnot consistent with the framework ofsocialvalidation.At theempirical level we need to identlfr more carefully the performanceassociated with differenttypes of property rights and to examine ina more open-minded fashion the property rights associated withsuccessful,nontraditional systems. Otherwise wecanfindas “answers”only thebeliefs we started out with.

ReferencesBurgstaller, André. “North-South Trade and Capital Flows In a Ricardlan

Model ofAccumulation,” Working Paper, 1983. ForthcomIng inJournal ofInternational Economics,

Gregory, Paul, and Stuart, Robert Soviet Economic Structure and Perfor-mance. 2d edition. New York: Harperand Row, 1981.

Kornal,Janos. “The Dilemmas ofa SocialistEconomy: The Hungarian Expe-rience.” CambridgeJournal ofEconomIcs4 (December 1980): 147—57,

Milenkovitch, Deborah DoltPlan and MarketIn Yugoslav EconomicThought.New Haven, Conn.: Yale University Press, 1971,

Milenkovitch, Deborah Duff. “Is MarketSocialism Efficient?” In Compar-ative EconomicSystema:AnAssessmentofKnowledge, Theory andMethod;pp. 65-108.Edited by Andrew Zlmballst. Boston: Kluwer-Nuhot 1983.

Noble, David F. “Social Choice In Machine Design: The Case of Automati-cally Controlled Machine Tools.” In Case Studies on the Labor Process,pp. 18—SO. Edited by Andrew Zhnbahst NewYork and London: MonthlyReview Press, 1979.

Pejovich, Svetozar. Market-Planned Economy of Yugoslavia. MInneapolis:University of Minnesota Press, 1965.

Pejovich, Steve. “The Incentive to Innovate under Alternative PropertyRights.” CatoJournal 4 (Fall 1984): 427-46.

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