Property Rights Approach to Government - Douglass C. North's Historic Economic Perspective on the Philosophy of the State

Table of Contents

I. Introduction

II. Property rights and their role for economic growth

III. Government and its role in economic organization
1. Public goods
2. Free-rider problem

IV. The role of economies of scale for property rights and fiscal policies
1. The existence of economies of scale on the market
2. Economies of scale influence on the fiscal policy

V. From feudal manor to the modern state
1. 10th century feudalism
2. The Malthusian trap of the 13th century – first changes in property rights
3. Famine, pestilence and war – further changes in property rights
4. The early modern period – 16th and 17th century
5. The Industrial Revolution and Second Economic Revolution
i. Industrial Revolution
ii. Second Economic Revolution

VI. A framework for analyzing economic organization in history – Norths model of the state
1. A model for economic growth
2. A theory of the state
i. North’s model of the state
ii. A theory of transaction costs
iii. A theory of ideology
iv. Deficiencies

VII. Theory of Institutional change
1. Underlying Institutional Framework
2. Implications for the political-economic system
3. Changes over time

VIII. Summary and Critique

bibliography

I. Introduction

The philosophy of the state treats the concept of the state: its origin, its being, its forms, tasks and purposes, as well as the institutional, ethical and juridical borders of the states activity. As a branch of the political philosophy and the general state philosophy the most different aspects of many single sciences, among them political science, jurisprudence, sociology and economics, are directly or indirectly touched.

Historically, different state theories can be assigned to different social structures of epochs and be derived from them. Those theories reacted according to their epoch to different needs and particular or general interests of certain groups. A possibility to order the variety of theories in a conceptual way is to approach the underlying assumption of human beings behavior and morality: where humans are considered to be good in principle, theory will be based upon a very extensive democratic participation, social equality and constrained ruling power. Contrarily, where humans are seen to be violent, power-striving or due to their principal indeterminacy potentially dangerous, theory implements a trend to legitimize the exercise of power of state authority that is based on the limitation of freedom.

Another approach towards the philosophy of the state is that of an economic point of view and argumentation. Not surprisingly, also in this field differences occur that most obviously arise around the question if and how the state should interact in market mechanisms. Three main theories were formulated, known as the classical, Keynesian and neoclassical theories.

Because science is a constantly developing field, newer attempts do already exist. Douglass C. North has added to the neoclassical theory of the market transaction costs, a changed rationality assumption and the dimension of time, to mention the three most important aspects. He does not only derive a new model of the state but also a new institutions economic of change. His approach on the development of states, however, is interestingly based upon the protection and establishment and enforcement of property rights.

II. Property rights and their role for economic growth

According to North for an economy to grow it needs the existence of an efficient economic organization. The establishment of institutional arrangements and the establishments of property rights are the underlying conditions for an economic organization to be efficient. Even if North later departs from the efficiency requirement of economic organizations, the main dependencies stay untouched. Furthermore, the property rights established need to be of that kind to “create an incentive to channel individual effort into activities that bring the private rate of return close to the social rate of return.” (North/Thomas 1973, p.1)

Economic growth, however, North defines as the per capita long-run rise in income. “True economic growth”, as North calls it, thus is a per capita improvement, the increase in income per person. Reasons for true economic growth to occur are given if the actual quantities of the per capita factors of production increase and / or if at least one factor of production experiences efficiency increases. Those efficiency increases again occur through the realization of economies of scale, in the course of the reduction in market imperfections that result from uncertainty and information costs (as part of transaction costs) or because of organizational changes that reduce market imperfections. Whereas technology changes, investment in human capital, the reduction in costs of market imperfections, economies of scale and the expansion of the population are said to be reasons for growth, North argues that they are not causes of growth but growth themselves.

As said before and according to North, true economic growth does not exist unless the existing economic organization is efficient. Consequently, individuals need incentives to undertake socially desirable activities, which they easily will do if the private and social rates of return are equal or at least not far apart from each other. This is exactly the point where property rights enter the scene: if property rights are not enforced or poorly defined the private rate of return will be far below the social rate of return and thus not giving any individual an incentive to undertake socially desirable actions.

But how come that property rights might not evolve? One reason might be a lacking technique to counteract the free-rider or to compel third parties to bear their share of the costs of transaction. Another reason, next to a lacking technique, and in my point of view even of higher importance, is that the costs of creating and enforcing property rights usually exceed the benefits to any individual or even any group. North does already in this point deviate from the neoclassical model because, contrarily to neoclassics where no transaction costs exist, North approaches reality and introduces positive transaction costs. Additionally, he argues that property rights are interdependent with the institutional structure of a society, where, if property rights change, the institutional structure needs to adjust and vice-versa.

For the continuing analysis, North only refers to those institutional arrangements that enable the realization of economies of scale, the encouragement of innovations, the improvement of the efficiency of factor markets and the reduction of market imperfections. Thus, he refers to institutional arrangements that increase efficiency and consequently lead to true economic growth. All of the above can be achieved with or without the changes in property rights’ allocation and some of the above can be accomplished by voluntary organizations, some by government. Since real costs occur in both cases the possibility of withdrawal is the characteristic that makes the distinction between voluntary organizations and government. Withdrawal from governmental taxation is only possible by migrating outside the political unit or by changing the law, thus implementing high costs of avoidance.

The governmental role in economic organization is consequently the key leading to North’s property rights approach to government that need to be looked upon further.

III. Government and its role in economic organization

As a first approximation, government is viewed as an “organization that provides protection and justice in return for revenue” (North/Thomas 1973, p.6). In the case of property rights, government will hence be paid in return for the establishment and enforcement of property rights. However, why should only government be able to do the above? In other theories of the state, especially those which are tending to be of the anarchic kind, little or no government is necessary since all of the above can be done by group or class activity – if not even the abolishment of common property rights claims is propagated – or by the market itself.

Traditional public choice uses the theory of market failure as a reason for state activity. Market failure arises in many cases, the most demonstrative, however, is the case of public goods. Group activity, on the other hand, too, has a severe reason to fail: the free-rider.

1. Public goods

Public goods are characterized through the absence of both characteristics that are typical for private goods: exclusion and rivalry. The principle of exclusion can not be applied to public goods since individuals can not be excluded from the consumption or use of a public good by technical means, even if they did not contribute to the public good’s supply. Additionally, rivalry does not exist which means that the consumption of one good by one or more people is not decreased in amount or quality. The consumption of public goods as such thus does not implement any difficulties, the supply, however, does. Public goods have, like any other goods, costs in production (c>0). Consumption, on the other hand, of a public good has a zero price (p=0). A private company that is producing public goods consequently could only offer those goods for a price greater than zero, whereas demand occurs only if p=0. On a market that is based on voluntary exchange this divergence leads to market failure.

2. Free-rider problem

Mancur Lloyd Olson’s theory on interest groups^[1] treats problems occurring to groups if all members behave rationally according to the theory of rational choice – maximizing their own utility. For group action this implies an incentive to deviate by becoming a free-rider. In the case of groups wanting to supply public goods, for instance the protection of a community, the incentive to deviate from participating in the supply is especially attractive. The so-called free-rider will not bear the costs of supply but enjoy the positive utility from consumption. His utility, as a result, is maximized. Deviation is especially high in large groups: the actual supply of a public good will most likely not change if one individual cooperates or not. Consequently, not to cooperate is the dominant strategy. The same holds for small groups, deviation here, however, might induce negative effects for the deviating individual: supply might not be hindered but reduced in amount or quality. The deviating individual does still not bear the costs but also enjoys smaller utility from consumption. In any case, if deviating is the dominant strategy, this applies to all individuals of the group: group action thus fails due to rational behaviour of the single members of the group or supplies only inefficient amounts.

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^[1] See Olson, M. (1965): The Logic of Collective Action.