Introduction and Opening Case: Institutions and Norms in Yucatán, Mexico
Economic models often assume away the laws of government, the norms of society, and the structure of organizations, but no economic activity would occur without a legal, social, and organizational framework. Laws, norms, and organizations are elements that contribute to social order and structure individuals’ efforts to coordinate, cooperate, and compete at levels ranging from the family to international trade. This chapter provides an introduction to institutions, which include laws, policies, and any other rules devised and enforced by a recognized authority. Institutions are defined by Douglass North (Reference North1990: 3) as “the humanly devised constraints that shape human interaction” and by Elinor Ostrom (Reference Ostrom2005: 3) as “the prescriptions that humans use to organize all forms of repetitive and structured interactions.” Institutions, together with the other elements of a social order, define property rights, the set of decisions that individuals can make about resources.
An example from Mexican economic history illustrates the interaction between institutions, norms, and organizations. During the henequen boom in Yucatán, the relationship between hacendados and the Maya workforce took a distinct form, described by American “muckraking” journalists as a system of debt peonage. While it is not surprising to learn that indigenous Maya worked in a coercive environment, the specific mechanics of the debt peonage contract are hard to explain without understanding the details of the institutions, norms, and culture of Yucatán. Henequen, a fiber extracted from the long leaves of the henequen agave and used to make twine for the McCormick binder, was Mexico’s most important agricultural export at the time.Footnote 1 The number of acres under henequen cultivation grew from 6,500 to 790,000 between 1860 and 1916, making Mérida, the state capital, an island of prosperity in a vast sea of henequen. Henequen plants lived twenty years, the first six of which were unproductive, making henequen a long-term investment. Harvesting, weeding, and planting occurred year-round, and workers quickly processed the leaves in a rasping mill located on-site. Many henequen haciendas had an internal trolley system that hauled workers to the fields and the cut leaves to the rasping mill. Supervisors assigned fieldworkers acres to weed or bundles of leaves to cut as a day’s task, but workers had the ability to shirk along many margins, including cutting too many leaves from a single plant, putting too few leaves in a bundle, or failing to weed properly.
Mexico’s Constitution of 1857 was the law of the land during the henequen boom. It outlawed slavery, going so far as to free any slave that stepped foot onto Mexican soil. A worker could not “be compelled to render personal services without due compensation and without his full consent.” Especially for its time, the enumeration of rights in the 1857 Constitution was exhaustive. The constitutional rules were not, however, the rules on the ground. An elite, which consisted of the thirty most prosperous henequen families (the Casta Divina [Divine Caste]), ruled the Yucatán. Political power was closely intertwined with economic power. Maya who were not attached to a hacienda were subject to a military draft and corvée service for road building and public works. At the local level, hacendados made rules of their own, enforceable through violence, and local political bosses supported those rules. Maya had little recourse to the courts, which the ruling elite controlled.
Two social norms structured labor relations between Maya workers and hacendados. The first was a norm that Maya workers had a relatively expensive wedding at an early age. This norm seems to have its roots in Maya culture, but its specific manifestation during this period was in the form of a Catholic wedding officiated by the local priest. Neither the workers nor their families could afford to pay for the wedding, so the hacendado for whom they worked lent them the money. While the hacendado recorded the loans on the books of the hacienda, in practice, they were never repaid and can be thought of as gifts from the hacendado to the young couple and their parents. This brings up the second norm, a norm of reciprocity. Workers reciprocated the hacendados’ gifts by staying on the hacienda and providing loyal-like behavior. Some workers fled and some paid off their debts, but most were born, worked, and died on the same hacienda. Hacendados provided additional paternalistic benefits to workers, including protection from military and work drafts, medical care for the sick, care for the elderly, and land to plant a garden. Given the coercive political and social environment that the hacendados themselves helped to create, Maya workers often found staying tied to a hacienda through debt peonage to be the best of a bad set of choices. Only by understanding the specific social, political, and economic environment can we understand this unique contractual mechanism of loans with no expectation of repayment. This chapter introduces some of these concepts, focusing on institutions, but we touch upon other elements that contribute to creating social order, including norms, organizations, values, preferences, and beliefs, to show their effect on economic outcomes.
A myriad of rules that can arise in many different ways shape human behavior. Governments create and enforce some rules, like speeding laws, while other rules, like the “golden rule,” have their roots in many ancient religions. Our goal in this section is to provide a classification of rules, distinguishing between rules that are an element of an institution or a norm. We make this distinction by examining how a rule is made and enforced. We define an institution as a rule that recognized entities purposefully devise and have the recognized right to enforce. Rules define what a designated party must, must not, or may do under a certain set of conditions and assign sanctions for non-compliance. Rule makers purposefully devise institutions, and the rule maker must be recognized as having the authority to do so. This authority is usually achieved through a collective-action process, governed by complementary institutions and norms. For example, citizens of a country recognize the government’s authority to create laws, and employees of a firm recognize management’s authority to make operating rules. Finally, entities, often not the rule maker, are assigned the rights or duties to monitor conduct and impose sanctions. Additional institutions and norms also govern the actions of the enforcement entities. For example, parents are recognized as having the right to punish their children to enforce household rules, but laws put limits on punishment. The law in many US states allows parents to use “moderate physical discipline” but forbids punishment that would result in “substantial harm” to a child. Additional rules govern the actions of police, plaintiffs, and courts.
We distinguish between institutions and norms.Footnote 2 A norm consists of a rule and a pattern of enforcement, both of which arise after repeated interactions in a path-dependent process. While individuals and organizations can attempt to shape norms through means such as education and religion, norms emerge over time. The process can be referred to as spontaneous order, which is generally used to describe the order that emerges from individual interactions in the market, any one of which lacks a centralized motive to create this order. Individuals follow the rule from an institution or a norm for many of the same reasons. First, following the rule helps them choose between multiple equilibria, such as driving on the right or left side of the street. Second, following or not following the rule can cause internal feelings of satisfaction or guilt. And, third, other parties provide inducements, either by rewarding rule-followers or punishing rule-breakers. For institutions, the rule-making entity may assign another entity the right or duty to enforce the institution. In contrast, the mechanisms that lead to norm-following emerge over time.Footnote 3 Constitutions, laws, organizational rules, and contracts are subcategories of institutions. Social norms and conventions are subcategories of norms. The dividing line between institutions and norms becomes blurred when institutions codify preexisting norms of behavior.
Rules assign rights and place constraints on human behavior by specifying what a defined set of individuals must, must not, and may do in certain situations and prescribe penalties for non-compliance. We borrow from Crawford and Ostrom’s (Reference Crawford and Ostrom1995) grammar of institutions, known as ADICO, to define the elements of rules.Footnote 4
The deontic, which specifies whether an action is obligatory, permitted, or forbidden, is a central element of a rule. As shown in Figure 1.1, those actions that are not forbidden are permissible, and those actions that are not obligatory are omissible. Actions that are optional are neither obligatory nor forbidden. The representation of the deontic in Figure 1.1 hides the reciprocal nature of the deontic: granting one person the right to take a specific action requires additional rules about the duties of other members of society. We will address the social relations involved in the deontic further in Chapter 2.
An institution, adopted by many colleges and universities, is an honor code that prohibits plagiarism. Students, faculty, and other stakeholders recognized higher education organizations (universities and colleges) as having the authority to define and enforce the honor code, making the honor code an institution. The institution’s rule states that: “Students at University of XYZ (Attribute) are forbidden (Deontic) from presenting someone else’s work as their own without proper acknowledgement (Aim) on papers and tests turned in for a grade (Condition). Doing so will result in an honor code hearing and sanctions as described in the Student Handbook (Or else).” These rules are limited to whom and for what activities they apply. University of XYZ’s honor code only applies to students at University of XYZ for work turned in for classes at that university. They do not apply to faculty at University of XYZ or students at ABC College. Honor codes describe the responsibilities of witnesses for reporting incidents of suspected cheating. It may be a violation of the honor code not to report suspected violations of the honor code.
A web of institutions and norms combines to influence social behavior. One way to sort out this web is to follow the creation of a new rule. For instance, in the United States, in order to become a law, a bill must pass through committees, both houses, and a conference committee, and then be signed by the president into law. An agency is charged with enforcing the law and the Supreme Court can rule on its constitutionality. All of these stages of the rule-making and enforcement process occur in linked arenas that have their own sets of institutions and norms that shape behavior.
Institutions range from the constitutional to the contractual level. Following Ostrom (Reference Ostrom2005), we limit ourselves to three levels of rules – constitutional, collective choice, and operational – all of which can occur at different levels of societies and in different organizations. Operational rules directly shape day-to-day behavior. Collective-choice institutions determine the process by which recognized entities make operational institutions. At the highest level, constitutional-level institutions specify the structure of an organization and the process by which institutions can be created and challenged. An organization, such as a college or university, may have a set of constitutional-level institutions in the form of a charter that describes its organizational structure, how that structure can be changed, and how new institutions can be created (McCubbins, Noll, and Weingast, Reference 373McCubbins, Noll and Weingast1989). Collective-choice institutions, in the form of student and faculty handbooks, structure the operation of the university. Operational institutions govern the day-to-day decision making at the university and include grading policies and the contracts with food and cleaning services. Constitutional-level institutions may be included in a formal constitution, but may also be a set of laws and principles that have the equivalent of constitutional standing. Such is the case for Great Britain, which has no codified constitution.Footnote 5
An example of a constitutional-level institution is the Third Amendment to the US Constitution, which prohibits the quartering of troops during a time of peace without the permission of the owner. If a property owner believed that an agent of the government violated this constitutional institution, the property owner must appeal to the court system to protect her rights. The constitutionality of laws can be reviewed by the courts in countries with judicial review. While the deontic in the Third Amendment is clear – unauthorized quartering during times of peace is forbidden – the “or else” points to a process of judicial review rather than an explicit penalty associated with the violation of the deontic. This enforcement mechanism is part and parcel of the social order. A country with no formal or informal means of enforcing constitutional provisions has constitutional institutions in form but not in function.Footnote 6
Some institutions devised by a recognized authority are not enforced because they are either difficult to enforce or the agency charged with enforcement chooses not to enforce them. We call these institutions-in-form, and distinguish between institutions-in-form and institutions-in-use, which are regularly enforced by a recognized authority.Footnote 7 “Enforced” does not mean that sanctions are automatically and costlessly imposed. Instead, it means there is a party assigned to enforcing the rule and a probability that violating a rule will lead to a sanction. If you steal your neighbor’s car, you may never be accused, you may be prosecuted but found not guilty of a crime, or you may be prosecuted, found guilty, and sentenced to pay a fine or serve a term in jail. Laws prohibiting theft are rules-in-use if there is an expectation that agents of the government will enforce the penalties in a predictable manner. When the costs of establishing and protecting property rights are positive – as we will see in the next chapter is always the case – enforcement of rules cannot be perfect.Footnote 8
The intended purpose of sanctions is well developed in the legal scholarship on retribution and deterrence: if one person murders another, societies have identified a value in punishing the murderer, but ideally, the nature of that punishment signals to other social actors that future murders will be similarly penalized. The extent to which punishment on its own right has social value absent from its deterrent effect is a matter of considerable scholarly debate, but evidence suggests that for many social actors, retribution has value. Sanctions can have additional intended purposes, depending on the nature of the dispute or crime committed. For contractual violations, as well as torts (a harm committed against an individual or their property), sanctions can also restore the harmed party, compensating her for the harm. Finally, incarceration carries the additional purposes of incapacitating and rehabilitating a given criminal, to the extent a given prison system is actually capable of accomplishing this.
Laws prohibiting usury illustrate the difference between institutions-in-use and institutions-in-form. Limits on interest rates go at least as far back as the Code of Hammurabi (1750 BC), which set the maximum interest rate that could be charged and the maximum length of time a debtor could be sentenced to debt slavery. Islamic, Christian, and Jewish traditions all have some form of a prohibition against usury, but charging interest or its equivalent has been widespread among people of all three faiths. In Islam, the interest ban has been ignored or circumvented via alternative arrangements, such as the use of a “double sale.” A double sale involves the borrower selling the lender an item and then immediately buying it back and promising to pay the lender the initial sale price plus a premium at a specified time in the future.Footnote 9 Merely knowing that Islam prohibits interest might make a student of Islamic banking think that no lending occurs. But knowing that alternatives exist might make students of Islamic banking think that there are no differences between Islamic and Western modes of banking. Neither of these suppositions is correct: arrangements that imperfectly mirror interest rates have existed in Islamic banking, but the differences between Islamic and Western institutions are important and have led to differing evolutions in their banking sectors (Kuran, Reference Kuran2011).
Institutions that support trade are among the most important for economic development. Contract law provides for the third-party enforcement of agreements through the judicial system by setting penalties for failing to fulfill contractual obligations. Figure 1.2 illustrates a simple investment game in which the investor (Jane) can invest or not invest, and the agent (Bob) can cooperate or breach. The payoffs to Bob and Jane are the monetary gain they will receive from the combination of actions. For instance, if Jane invests and Bob breaches, Jane loses $100 and Bob earns $100. Assume initially that Jane and Bob seek only to maximize their monetary payoffs and that there are no mechanisms in place to enforce that agreement. If this interaction took place on a farm, Jane could buy a mule and a plow, while Bob could cooperate by using that equipment to farm the fields. Breaching the agreement could involve Bob appropriating Jane’s investments and selling them or using them to farm elsewhere.
Sequential move games, such as the one described in Figure 1.2, are solved via backward induction. At decision node b, Bob’s optimal strategy is to breach, earning him a payoff of $100 versus $50 from cooperating. Bob will therefore breach. Knowing this, Jane will not invest at decision node a. The lost $100 in social surplus is a deadweight loss.
Courts in the United States traditionally require the elements of offer, acceptance, and consideration for a legally binding contract to be formed. In this case, Jane offers to provide the equipment if Bob promises to farm the land with it. Bob can either accept or reject that offer. The provision of the farming equipment by Jane can act as consideration, the inducement to the contract. One way to encourage cooperation is to penalize Bob for breaching by making him pay perfect expectation damages, which state that if Bob breaches the contract, he must pay Jane enough money to put her in the position she would have been in had the promise been fulfilled. The payoffs from perfect expectation damages are shown in Figure 1.3. If Bob breaches, he must pay Jane $150 to give her a total payoff of $50, which is what Jane would have received had Bob cooperated. These damages give Jane the incentive to invest and Bob the incentive to cooperate. The set of strategies (invest, cooperate) in Figure 1.3 is a Nash equilibrium, as neither player has an incentive to change his or her strategy given the strategy of the other player.
In a world in which contracting is costly, the size of damages awarded to the injured party matters. A fortunate or unfortunate contingency may raise the opportunity cost of performance so that it is inefficient to perform. If damages awarded by the courts are too high, then promisors will complete too many contracts. If damages are too low, then promisors will complete too few contracts. By setting damages correctly, courts can encourage optimal performance and breach of contracts.Footnote 10
Rewriting the payoffs in Figure 1.2 to transfer $150 from Bob to Jane when Bob breaches presupposes a legal system that can costlessly and flawlessly interject itself into private agreements to establish and enforce property rights.Footnote 11 Among the many factors influencing the enforcement of contract law are the accessibility and funding of the courts; the training, honesty, and diligence of judges; the rules of evidence; the laws regulating the organization of the legal profession; and the norms of legal reasoning (Hadfield, Reference Hadfield, Ménard and Shirley2005). Rewriting the payoffs also presupposes that using the judicial system to settle disputes is an accepted practice and that Jane and Bob both have the expectation of having the rules applied in an equitable manner.
It is important to note that our definition of rules encompasses both rules and standards as they are typically distinguished in the legal literature. A good example is a speed limit: drivers traveling at a speed greater than the stated limit of 65 mph are typically subject to a fine and additional penalties on their driving records. However, some jurisdictions have instead employed a standards-based approach, such as Montana, where for a period the standard was that a person was to drive reasonably given the nature of the road and the ambient conditions. A rule is precise as compared to a standard. Individuals charged with driving at 79 mph in a 65 mph zone do not have a lot of room for argument before the enforcing court or officer that their behavior was actually legal. If the radar machine identifies a car as travelling at a specific velocity, it is well accepted that the precise machine did not somehow “get it wrong.” In contrast, a motorist in Montana under the “reasonable” standard could employ a variety of arguments to the enforcers as to why 79 mph was reasonable given the weather conditions and level of traffic on the road. Ostrom’s ADICO definition of a rule is clearly one that incorporates standards as we define them. It is the aim (I) that is vaguer in a standard (drive safely) than a bright-line rule (don’t drive faster than 65).
This distinction between rules and standards is an important institutional tool for legislators and policymakers when considering the benefits of each. Rules tend to be more easily enforced than standards, but by this same token, remove discretion from the enforcer in terms of their ability to determine whether a given individual’s conduct violated the social rules animating the particular broader standard. Therefore, these examples also highlight the importance of the role of the enforcer. In many jurisdictions, the police don’t pull people over at 66 mph, despite the bright-line nature of the rule in play. Relatedly, in Montana, the imprecise standard was ultimately overturned by the courts because it gave enforcers far too much discretion in choosing who to pull over, which led to discriminatory outcomes in terms of policing practices.
The payoffs listed in Figures 1.2 and 1.3 associated with the investment example show the monetary gains or losses from participating in the game. But economic actors respond to more than monetary payoffs; they may therefore follow strategies that, on the surface, do not look rational. A strong preference for acting in a cooperative manner could overcome Bob’s incentive to breach and Jane’s hesitance to invest in Figure 1.2. Similarly, a norm of cooperation might lead to the cooperative outcome. A social norm of cooperation is followed when there is a chance of being observed by others. Being observed would generate a feeling of contempt by the observer towards the violator. That contempt may lead to punitive actions (shunning, confronting, physically accosting) by the observer and feelings of shame by the violator.Footnote 12 In order to avoid the disutility from this combination of external or internal sanctions, the potential norm-violator may choose to cooperate rather than breach.
Norms can govern behavior “contrary to nature,” reciprocity, retribution, cooperation, distribution, work, and consumption. Norms of behavior “contrary to nature” include prescriptions against incest and cannibalism. Norms of reciprocity and retribution guide the exchange of benefits and harms. Norms of cooperation prescribe the degree to which people cooperate in situations like a prisoner’s dilemma game. Distribution norms determine what is considered a “fair” distribution of society’s resources. Work norms guide how hard and in what manner one works. Consumption norms indicate what types of goods and services are expected to be consumed by members of a particular group. This list is far from exhaustive, but gives a sense of the many ways in which norms can affect behavior.
In any situation, individuals can choose the set of norms upon which they will draw. Employers can appeal to a work norm (a job well done is its own reward) or norms of distribution (if the company is not profitable, it cannot afford pay raises). Workers’ appeals to norms are reflected in many union slogans, such as cooperation (Workers of the world, unite!), reciprocity (A fair day’s wage for a fair day’s work), or distribution (Eight hours for work, eight hours for sleep, eight hours for what we will). If employers invoke a norm of distribution to share the losses of a poor harvest, a norm of reciprocity can be invoked by workers to share the wealth of a bountiful harvest. The same norm may be drawn upon to advocate for opposite policies. The anti-welfare slogan “Entitlement Nation” and the anti-Wall Street slogan “The 99%” both appeal to a norm of fairness.
Norms vary in their expansiveness and their importance. Norms can apply to multiple cultures (incest and cannibalism are forbidden in most societies); a single society (the nineteenth-century Corsican code of honor [Elster, Reference Elster2007: 362]); a religious group (the Christian day of rest is Sunday, the Jewish day of rest is Friday to Saturday sundown); a school (students at XYZ College “work hard and play hard”); or a business (everyone works late when a big project is due the next day). Norms can also vary in their importance. A “contrary to nature” norm forbidding cannibalism is more substantive than a fleeting consumption norm regarding fashion. The consumption norm of spending a lot on a wedding is fairly widespread, but the sanctions for violating the norm vary. Walking on the right side of the sidewalk or the right side of the grocery aisle is a norm, but it is neither that important nor is it universally followed, as shoppers swerve from side to side as they find items or text on their phones.
While institutions and norms are the rules of the game, individuals are the players. Individuals are the foundational unit of analysis in economics. Methodological individualism holds that only individuals, not organizations, have goals or aims and that changes in social outcomes are due to the actions of individuals.Footnote 13 We highlight four characteristics of individuals that differ from the typical textbook presentation: their rationality, preferences, values, and beliefs.
A typical microeconomics textbook models individuals as rational egoists who maximize their material well-being subject to a set of constraints.Footnote 14 In these models, individuals can gather and evaluate information about alternatives in a costless manner. The strong assumptions regarding the availability and processing of information led Herbert Simon (Reference Simon1961) to posit that economic models should be built on a weaker version of rationality. Actors who are boundedly rational are “intendedly rational, but only limitedly so” (xxiv). Bounded rationality assumes that there are limits to humans’ ability to gather and process information. For this reason, individuals may regret actions ex post that seemed optimal ex ante. Actors use tools such as satisficing behavior, rule following, and incomplete contracts in order to compensate for their bounded rationality.
Individuals possess a complex set of preferences, values, and beliefs that complicate the modeling of utility as a monotonic transformation of material outcomes. Preferences and values are normative statements. Preferences describe an individual’s tastes for “consumption and personal affairs” while values describe an individual’s tastes for the ordering of “society and social relations (often thought of as ethics and ideology)” (Mokyr, Reference Mokyr2017: 8).Footnote 15 Preferences and values can come from norms that have been completely internalized, but can also be independent of norms. Beliefs are positive statements that “pertain to the state of the world, including the physical and metaphysical environments and social relations” (Mokyr, Reference Mokyr2017: 8). Preferences and values describe how an individual thinks the world should work, while beliefs describe how an individual thinks the world does work.
A student might prefer that other students in a class not cheat on an exam. That student may simultaneously believe that cheating is rampant. The phrase “believe what you want” implies that people’s preferences, values, and beliefs are intertwined. Limited government advocates believe that smaller government will generate prosperity and also prefer tax cuts. Big government advocates believe that government intervention is required to fix basic faults in the market economy and also prefer expansive regulatory policy. We return to the importance of beliefs in the Enforcement versus Equilibrium section below.
An individual’s preferences, values, and beliefs are partially learned – organizations such as families, churches, schools, and governments work hard to socialize children into certain patterns of behavior – and are partially evolved – certain characteristics have been selected for over time. Detailing the source of preferences is a core question in the field of evolutionary psychology and well beyond the scope of this book.Footnote 16 There is a difference between a norm, which is an action or set of actions that society expects or permits in a given situation, and the impulse that undergirds that behavior. You may feel a desire to exact revenge on someone who has recklessly cut in front of you in traffic. The impulse for revenge is an intuitive response to perceived harm that may be learned or may be genetic. The norms and laws of society shape the form of the revenge.Footnote 17
Models based on narrowly defined self-interest can make accurate predictions in certain arenas of economic action, most notably in situations that loosely reflect the assumptions of perfect competition. However, situations in which the social order encourages behavior other than competition are often difficult to explain using a model based on the rational egoist assumption.Footnote 18 Donating to charitable organizations; working harder than required; unwavering loyalty to a sports team, country, or brand; voting for policies that hurt your material interests; and automatic acceptance or subversion of authority all require explanations that go beyond the maximization of material well-being. Humans are competitive by nature, but also are willing cooperators, particularly when the social order in place encourages cooperation. For this reason, we use a broad definition of rationality – choosing the best means possible to achieve the chooser’s ends – rather than one focused narrowly on material well-being.Footnote 19
While individuals have beliefs, values, and preferences, those elements, when shared by a group, make up that group’s culture. Mokyr (Reference Mokyr2017: 8) defines culture as: “a set of beliefs, values, and preferences, capable of affecting behavior, that are socially (not genetically) transmitted and that are shared by some subset of society.” In explaining the origins of the Industrial Revolution, Mokyr argues that at the time of the Enlightenment, a culture of “open science” among scholars, engineers, and other elites encouraged them to share information in the public realm. Elites within this culture shared the belief that scientific discoveries and their application could be the source of continual improvement in the human condition.Footnote 20
Families, firms, religious organizations, colleges, and governments are all organizations. Organizations form when individuals join together to achieve a set of common objectives. North, Wallis, and Weingast (Reference North, Wallis and Weingast2009) distinguish between adherent organizations and contractual organizations. An adherent organization is “characterized by self-enforcing, incentive-compatible agreements among its members,” while contractual organizations “utilize both third-party enforcement of contracts and incentive-compatible agreements among members” (North, Wallis, and Weingast, Reference North, Wallis and Weingast2009: 16). The state is an adherent organization, as no exogenous party enforces the constitution. A group of mafia bosses that comes to an understanding about splitting territory or a group of basketball players playing a pick-up game are also adherent organizations, since in neither case is there an overarching organization that enforces the rules. A corporation, on the other hand, is a contractual organization, as it relies on the state to enforce some of its agreements.
Organizations are interesting to the Institutional and Organizational Analysis (IOA) because they create and enforce the bulk of the institutions studied by the discipline. Organizations have two sets of related issues that we will examine. First, they have their own set of institutions and norms that govern their members’ behavior. Second, they “impact and interact with the broader world around them” (Greif and Kingston, Reference Greif, Kingston, Schofield and Caballero2011: 19). Analyses of the internal workings of organizations use tools from sociology, psychology, labor economics, and the modern theory of the firm. The goal is to understand the functioning of organizations that compete against one another in market settings. Since a variety of organizational forms (each with its own set of institutions and norms) are available to achieve a particular goal, one would expect competition among organizational forms that leads to efficient organizational choice. In Chapters 2 and 3, we examine this topic further. Organizations can impact the broader world by shaping preferences through education or advertising. They can also be players in the political process, seeking to shape legislation or coordinate to achieve large-scale institutional change. The influence of organizations in shaping political outcomes is examined in Parts II and III.
Enforcement versus Equilibrium Behavior
In a simple formulation of this framework, organizations and individuals enforce the extant institutions perfectly and costlessly. Property rights are therefore perfectly defined. Thinking about institutions as having clearly defined and enforced sanctions is a good first step towards understanding their effect on behavior. If the severity of a sanction associated with an institution is increased, we expect the quantity demanded of the prohibited activity to decrease. Under this view, if the government raises the fine for speeding, the quantity of speeding will decrease. An alternative Equilibrium framework notes that many patterns of behavior within organizations and societies persist with very little monitoring or enforcement of sanctions.Footnote 21 Greif and Kingston (Reference Greif, Kingston, Schofield and Caballero2011: 25) note that “it is ultimately the behavior and the expected behavior of others rather than prescriptive rules of behavior that induce people to behave (or not to behave) in a particular way.”
Though many patterns of behavior are influenced by institutions or norms, those patterns can be explained as equilibrium outcomes. The use of language is a matter of convention. Without a mutual understanding of what words mean and how grammar should be used, communication would be impossible (Lewis, Reference Lewis1969). We use the words on this page in the ways that we do because we expect our readers to share a similar understanding of their use and meaning. Driving on the right side of the road in the United States is a law and a social norm, but it is the expectation in equilibrium that others will stay to the right that is the greatest inducement to drive on the right. It is a law, because driving on the left side of the road will cause the police to pull the offender over and fine him, and it is a social norm because other members of society who observe the behavior feel and express alarm at the violator’s actions. But, even without the law or the social norm, people would still find a means to coordinate their behavior to a single side of the road. Take the example of the simple game shown in Figure 1.4 of a one-period simultaneous move game. Two drivers are speeding towards one another on a narrow dirt road and need to swerve either left or right to avoid an accident.
There are three Nash equilibria in the game: both drivers choose right, both drivers choose left, and both drivers randomize and go right 50 percent of the time and left 50 percent of the time. Without more information about the vehicles, the players, or the history of driving, there is no clear way to settle on one of the three equilibria. Staying to the right or left is an arbitrary decision, and the convention concerning which side of the road to drive on has changed over time. The dominant convention in much of continental Europe switched from the left to the right at the time of the French Revolution, but the process of switching was protracted, including switches by Hungary and Czechoslovakia during German occupation during World War II and ending with Sweden in 1967 (Young, Reference Young1996). A convention of everyone driving on the right side of the road needs no enforcement. It is a Nash equilibrium, a focal point (Schelling, Reference Schelling1960), and the outcome of a path-dependent series of events. Once drivers have the expectation that other drivers will swerve right, then swerving right is the focal point equilibrium.
Any institution or norm is embedded within other competing and complementary institutions and norms that will affect individuals’ behavior. Higher expected penalties for not following a rule may increase compliance, but the effect of a change in a rule on the rest of the social order is not always clear. For instance, suppose a university raises the penalty for being found guilty of cheating on an exam from failure of the exam to automatic expulsion from the university. The university administrators anticipate that this increase in the penalty will lower the quantity of cheating. But raising the penalty may have other effects. Raising the penalty may signal to would-be cheaters that infractions are caught infrequently. Would-be cheaters may therefore cheat more, knowing that the chances of getting caught are so low. Additional effects may increase cheating further. Suppose there is a consensus on campus that the new set of sanctions is “too strong.” Behavior will therefore change on a number of margins. Raising the penalty may cause students to not report observed infractions to the formal system. It may cause faculty members who observe cheating to adjudicate outside of the formal system to avoid having their students expelled. It may also cause the organization charged with hearing cases of cheating to be less likely to find an accused student guilty. Looking simply at the increase in the fine, one would expect cheating to fall. But if the increased fine causes the formal process to break down, then the equilibrium level of cheating may actually increase. University administrators may tout the reduction in cheating due to the increased penalty, but what they may be observing is not less cheating, only less reporting of cheating.
Workplace rules offer another example of competing and complementary institutions. Workplace rules often enumerate a list of activities that are forbidden or a minimum level of effort that is required. But “for the organization to work well, it is not enough for employees to accept commands literally. In fact, obeying operating rules literally is a favorite method of work slowdown during labor-management disputes, as visitors to airports when controllers are unhappy can attest” (Simon, Reference Simon1991: 32). In a workplace, where a great deal of initiative is required by employees, institutions can only set a minimal baseline of behavior. The true determinant of work effort is not the institution but the norms of behavior and the expectation that any one worker has about her coworkers’ levels of effort.
De Jure and De Facto Property Rights
Were institutions perfectly enforced, individuals would always follow the prescriptions of what they must, must not, or may do, thereby defining individuals’ property rights. One framework in the legal scholarship for understanding what the word “property rights” means is that it consists of a bundle of legal relationships, often called a “bundle of sticks” or a “bundle of rights,” that can be separated, combined, altered, traded, and described both individually and collectively. The law of property is not about our relationship with objects but about our relationships with other people, and those relationships change over space and time. This framework for studying the component parts of property traces back to Hohfeld (Reference Hohfeld1913, Reference Hohfeld1917), who argued that property was composed of four dyads: rights-duties, privileges-no rights, power-liability, and immunity-disability.Footnote 22 Hohfeld’s framework allows legal scholars to break the legal relationships associated with property into their component parts to clarify their exact form. When we begin to list these relationships, we see quite quickly that a piece of property includes a long list of abilities and restrictions that both the “owner” of the property and other members of society possess (Alchian, Reference Alchian1965; Barzel, Reference Barzel1997). An owner of a piece of land might have the ability to sell, lease, or subdivide it, while society may have the ability to regulate, tax, or take it for public use.
Suppose that you own a house and the land on which it is located. The property may be zoned single-family residential, so building an apartment or commercial building is forbidden. The property may contain wetlands or an historical building, the regulation of which may diminish your ability to build. You may be restricted to whom you sell your property.Footnote 23 You may be restricted in your right to rent out your house.Footnote 24 If you are allowed to rent out your house, there may be laws controlling how much rent you can charge.Footnote 25 Surface and subsurface rights to land can be separated; one person can own the right to build on a piece of land, while another owns the right to mine for coal on it.Footnote 26 Other people may have the right to enter your property without your explicit permission.Footnote 27 The courts may find that certain activities on your property are forbidden because they interfere with your neighbors’ enjoyment of their property.Footnote 28 You may be limited in your ability to hang your laundry to dry, host concerts in your backyard, or install a new water heater.Footnote 29
To give a flavor of Hohfeld’s framework, suppose that local regulations grant you the privilege to use the water in a pond on your property to irrigate crops. Under Hohfeld’s framework, your neighbor has a corresponding “no right”; that is, if you have the privilege to use the water, your neighbor has no right for you not to irrigate your crops with pond water. However, a privilege to use the stream does not mean your neighbor has a duty to not interfere with your collection of water. If your neighbor collects the water first, that means that you cannot collect that same water. Alternatively, you may have the right that your neighbor cannot take water from the pond without your permission. If so, your neighbor has the corresponding duty not to take your water. Your right and your neighbor’s duty mean exactly the same thing. This symmetry highlights the social nature of property. You may, through contract, exchange some of your rights and privileges with your neighbor, perhaps selling her some of your water or collectively deciding to set aside some water for conservation purposes. Once we view property as a “bundle of sticks,” those individual sticks in that bundle can be rearranged via contract.
In practice, the property rights associated with water are very complicated.Footnote 30 The rights to water in the eastern and western United States are roughly divided by the riparian and prior appropriation doctrines governing their use. The riparian doctrine allows landowners located next to a watercourse to use that water so long as the water is used on the adjoining land and does not interfere with their neighbors’ use. This allocation of property rights to water seems most appropriate “where precipitation and streams are plentiful and more-or-less uniformly spread” (Libecap, Reference Libecap2007: 283). In the arid West, water is both scarcer and more unevenly distributed than in the eastern United States, and often must be transported great distances to its final use. Because of this, a riparian system of rights has several disadvantages as compared to prior appropriation in areas of greater water scarcity. In areas of comparative plenty, the “reasonable” use standard underlying the riparian doctrine is typically sufficient to govern different adjacent users’ behavior and so results in fewer disputes. In a water-scarce environment, such a comparatively vague standard, especially untethered to clear appropriative priority of water users, would be much more likely to result in significant legal disputes. Instead, prior appropriative states rely on a more stringent requirement typically known as “beneficial” use.
Similarly, the adjacency requirement of riparian water use limits transportation of water in a way that would have hindered development along the western frontier, where in many contexts the most productive mining or agricultural land was not necessarily immediately adjacent to a source of water. The doctrine of prior appropriation allows for such transportation by assigning property rights to water according to the order in which users put it to beneficial use, even if the water is used far from the water source. Under the appropriation doctrine, you can have a stream running right through your property but not have the right to use the water in it.Footnote 31 This allocation of property rights allows for greater trade in water rights, although current law in most states still hinders trade (Culp, Glennon, and Libecap, Reference Culp, Glennon and Libecap2014).Footnote 32
While rights and privileges are distinct concepts, we generalize and use the term “de jure property rights” to describe all of the legal relationships included in property: rights, privileges, powers, immunities, and their correlatives. There are many entitlements that can be analyzed using the property-rights framework. Real property refers to land and anything attached to it. Personal property includes items that can be tangible (cars, iPhones, and books) or intangible (stocks, patents, and copyrights). Scholars can also use the property-rights framework to analyze other entitlements, such as human rights and political rights. The Bill of Rights in the US Constitution and the Universal Declaration of Human Rights (UDHR) both define rights that are held by individuals and duties held by governments. The US Constitution’s Second Amendment includes the right to “keep and bear arms,” and the First Amendment includes the right to “peaceably assemble.”Footnote 33 The UDHR includes the “right to a nationality” and “the right to marry and to found a family.”
A danger in using the “bundle of sticks” metaphor is that it might leave the impression that “property rights are purely ad hoc assemblages of rights and privileges” that can be separated and combined in an infinite number of combinations (Merrill and Smith, Reference Merrill and Smith2011: S89). This would be true if the costs of separating and assembling those rights and privileges were zero. Merrill and Smith argue that in a world in which these costs are not zero, property rights take some standard forms. We will return to the costs of arranging property rights in the next chapter during our discussion of transaction costs, but give three insights here.
The first insight is that the most important right that owners of property have is the right to exclude others.Footnote 34 This right of exclusion makes the owners of property the residual claimants – they control any property rights not enumerated in the law and receive any benefits not controlled by others. Property owners therefore have the incentive to invest in and develop their property in ways that no one else does. Second, the costs of figuring out what rights are bundled together and who owns those rights would be “staggering” in a world in which every piece of property had a unique set of rights associated with it. To minimize these costs, the institutions governing property generally fall into one of several categories. New and exotic property-rights schemes do arise, but they are often difficult to manage. A sign stating “Keep Out!” is much easier to understand than a sign stating “Keep Out! Unless …” followed by a long list of exceptions. Third, these rights against the world are asymmetric. While the “bundle of sticks” framework suggests that property rights can be arranged on a case-by-case basis between every member of society, doing so is much more costly than lumping all rights, such as the right of exclusion, together.
We have discussed property rights in this section using a legal framework, but economists define rights more broadly. Given that the complete delineation and enforcement of de jure property rights is impossible and that someone must be the residual controller of those undefined and unenforced property rights, many uses to property fall outside of the legal boundaries. Many of those uses may be limited by social norms that are not consistent with laws, but uses may not be fully limited by laws or norms. Because institutions and norms are hard to enforce, owners of property have the ability to use it in ways that fall outside of their bounds. We therefore define a de facto property right as the ability to make a decision about resources, including human, physical, or intellectual capital, both in the present and in the future. A de facto property right gives an individual or an organization the ability to “possess, use, improve, exclude, destroy, sell, transform, donate, bequeath, lease, mortgage, consume, or develop an asset” (Allen, Reference 354Allen2006: 4). These de facto rights can overlap with the rights as defined by the state, the de jure property rights. But de facto property rights can exist without the state or state enforcement, as shown by Umbeck (Reference Umbeck1981) and Ellickson (Reference Ellickson1991). They are also generated by organizations and individuals at all levels of society. We will use this expanded definition of property rights in Chapter 3 when we define transaction costs.
Another justification for property rights is natural law. An eighteenth-century Enlightenment version of property advocated by Quesnay was that property rights “were deeply embedded in a set of natural laws that had been worked out by the creator and were clearly discoverable in the light of human reason” (Rothbard, Reference Rothbard1995: 369). De facto and de jure property rights can, and often do, overlap with natural property rights, but one can possess one right without the others. This is especially the case given that the definition of natural rights requires elaboration by an authority, whose pronouncements as to which rights are “natural” can change over time.
Examining the property rights associated with slavery shows the overlap between natural, de jure, and de facto rights. Doing so also allows us to see how the costs of enforcing institutions drive a wedge between de jure and de facto rights. As defined by the Catholic Church’s position, the natural right to own slaves has changed over the centuries, depending on economic, political, and social forces. The position laid out in Vatican II in 1965 is that slavery is an infamy that poisons society. During the nineteenth century, the church’s position was more mixed, ranging from a description of slavery by Cardinal John Henry Newman as “a condition of life ordained by God in the same sense that other conditions of life are” to the condemnation of the slave trade by Pope Gregory XVI as “absolutely unworthy of the Christian name” (see Noonan, Reference Noonan2005). A clear, “natural” right to one’s own person did not exist for slaves during the era in which slavery flourished.
In the US South, slaves were considered to be the legal property of their owners. The laws of individual states dictated the specific rights of slaves. Some laws, such as how slavery passed from mother to child, were similar across all states. Other laws, such as the penalty for killing a slave, varied widely. In North Carolina, the ruling in State v. Mann (1829) stated that owners had the right to punish their slaves in any way they deemed necessary, including killing them (Tushnet, Reference Tushnet2003). In other jurisdictions, slaves had greater protection under the law from physical abuse. Some slave codes allowed slaves to live away from the owner’s property and contract with others for their services. Other codes forbade a slave from contracting.
While slaves were the legal property of their owners and strictly limited in their de jure rights, they did possess some de facto rights. These rights to make decisions over the use of resources arose because slaves were not automatons, allowing their owners the ability to control their every action. Slaves were human actors whose work effort needed to be incentivized, monitored, and enforced. An uncooperative slave could engage in work slowdowns, petty theft, sabotage, and any number of “weapons of the weak” (Scott, Reference Scott1985). Slaves were given the ability to use land, their free time, and even to purchase their freedom, even when legal rights did not exist. Even negative incentives, such as whippings, were only required because slaves had the ability to make decisions about work effort. Owning another person de jure does not imply having complete de facto property rights over that person.
If de facto property rights were undefined, any attempt to use or improve an asset could immediately be thwarted or appropriated by other individuals. Institutions and norms are central elements in the definition of property rights. They are ubiquitous, although their specific form varies considerably from place to place. Just as an absence of institutions and norms would beget chaos, their ubiquity indicates the value they provide in facilitating social order. While the grammar of any one rule can be analyzed in isolation, a web of institutions, norms, organizations, and individuals shapes the way in which any particular rule is promulgated, perceived, and enforced. These elements define and determine the distribution of de facto property rights. It is never the case that de facto property rights are perfectly defined; there are always costs associated with their establishment and protection. These costs, called transaction costs, are discussed in the next chapter and are the next major building block of the IOA.