6 INTRODUCTION TO THE RULES OF THE GAME AND
ECONOMICS SYSTEMS
Whether a society emphasizes the use of exchange, reciprocity or
eminent domain to allocate resources, “Any economic system requires a set of
rules, an ideology to justify them, and a conscience in the individual which
makes him strive to carry them out.” (Robinson, p 13) This set of rules
includes informal institutions and values held by individuals as well as formal
law. The structure of the rules of the games shapes the society’s economic
system. Neoclassical microeconomics does not often explicitly consider the
nature of these rules and their relation to economic behavior.
6.1 ECONOMIC SYSTEMS
Societies that fail to meet minimum subsistence requirements for its
members become relics of the past. Ideally, an economy will produce more
than necessary for subsistence and apply the additional output to improving
the lives of the members of society through development and/or economic
growth. The ideas of “progress,” economic development and economic growth
came with the development of the commercial world that replaced the feudal
society of the medieval world.
An economic system consists of a matrix of social institutions (law, political
institutions, religion, etc), agents (individuals or actors), organizations
(corporations, unions, charitable org, not-for-profit firms, etc) and society. The
principles, beliefs and values held by individuals are included in the structure
of society. The function of an economic system is to coordinate the activities of
agents in the processes of provisioning and allocation. Nonmaterial
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6.1 Economic Systems
characteristics of life (social stability, low crime rates, a sense of community,
etc) are related to the economic processes and should be included.
Robert Heilbroner identifies thee basic types of economic systems. These
are classified as markets, command, and tradition. In practice, most
economies are a mixture that includes elements of all three. However, the
economic system is usually classified by the dominant approach. Markets and
command exist in traditional economies. Tradition and markets exist in
command economies. Western industrial societies categorized as “market-
oriented” economies rely primarily on exchange, but contain elements of
tradition and command. In market economies tradition is important to such
decisions regarding values, expectations about behavior (trust, loyalty, etc.),
fashion, preferences about housing, choices about occupations and geographic
preferences. Command is also found in market economies as regulations and
laws regarding the allocation or resources and goods.
6.1.1 TRADITIONAL ECONOMIES
Traditional economic systems are based the repeated use of solutions that
have worked in the past. Solutions to problems in the processes of production,
distribution and consumption are embedded in the customs, mores and
cultural patterns of social life. These solutions have been established through
trial and error: those activities that result in adequate production and an
acceptable distribution are retained and used often without question. Agents in
traditional societies may engage in exchange transaction but these are
peripheral to the provisioning and allocation problems.
The traditional economic system tends to be found in non-industrial
societies that are engaged in hunting, gathering, pastoral, or basic agriculture.
Often these are subsistence economies: there is little or no growth or
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6.1.1 Traditional Economies
progress. The aboriginal culture in Australia is an example of an economy that
has flourished for thousands of years (40,000 years by some estimates) as a
traditional economy.
Traditional economies tend to depend upon a deontological ethic. Duties to
other members of the family, tribe or clan and “reciprocity” are the primary
allocative mechanisms. The forms of production that individuals engage in are
based on the processes that have worked in the past. Social institutions, such
as religion, may evolve to reinforce the traditional ways.
These societies must communicate behavioral expectations to each new
generation. The most important form of knowledge may be contained in
stories and myths. Mythology and story telling are important aspects of the
creation and communication of cultural values. Webster’s Encyclopedic
Unabridged Dictionary of the English Language gives one of the definitions of myth
as:
“an unproved collective belief that is accepted uncritically and is used to
justify a social institution.”
Keen and Valley-Fox describe myths as:
“… an intricate set of interlocking stories, rituals, rites and customs that
inform and give the pivotal sense of meaning and direction to a person,
family, community or culture.” (Keen, p xii)
Mythology is one of the processes by which cultural values and
expectations about behavior are transmitted from generation to generation.
Even in modern societies, stories are fundamental to the process of creating,
and perpetuating culture in societies.
Reciprocity is often a key element in traditional economies. Remember that
reciprocity is based on duty and involves obligatory gift giving: I do you a
favor and both you and I (and other members of society) expect that you will
return some unspecified favor at some unspecified time in the future. It
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6.1.1 Traditional Economies
requires a sense of duty, social values and a community to enforce
reciprocation. Social institutions give structure to the values, duties and
expectations about economic behavior.
In many societies, reciprocity becomes an important element of the social
process. In a ranching community Rancher Smith goes to the other ranchers
and says: “I need some help branding my calves next Tuesday, I’d appreciate
some help.” On Tuesday, the ranchers show up at Rancher Smith’s place and
help with the task. If Rancher Jones does not come to help, it may be for a
good reason. However, if he or she is perceived as shirking his or her duty, it
may be difficult for Jones to get neighbors to help with future tasks. Similarly,
if everyone helps Rancher Smith but then at some point in the future Rancher
Smith does not reciprocate by helping someone else fix his or her fence, then
Rancher Smith may find it difficult to get anyone to help in the future. There is
a community that expects that the other members will help when needed and
will reciprocate in the future. The community must communicate the
willingness of its members to participate in mutual aid and to sanction
members who do not fulfill their obligatory duties.
Notice that the substance of the event is different if Rancher A says: “I’ll
pay you $10 per hour to help me brand my calves.” Shifting the process from
reciprocity to a market exchange significantly alters the relationships and the
nature of the event. In the case of reciprocity, there is a sense of community.
The relationship between the members of the community may be of value in
and of itself. Blood and organ donations are examples. Moving a good or
activity into a market transaction may significantly alter its meaning or value.
A market exchange can take place between anonymous individuals.
As communities become larger, more complex and social relationships are
altered: tradition may be less useful as an allocative mechanism. It is more
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6.1.1 Traditional Economies
difficult for the members of the community to communicate the extent to
which the members fulfill their duties. Social pressure to enforce obligations of
reciprocity and duty may become less effective since each person has more
relationships that may be more valued.
Another weakness of a traditional economy is that it does not adapt quickly
to changes in technology or the environment. So long as there are no (or few)
changes in the environment, technology or external forces, the traditional
economy is stable or static. However, if there are sudden changes in the
environment, the traditional solutions may no longer suffice. Droughts,
desertification, over hunting specific animals are examples of events that
traditional societies may not be able to deal with. Native Americans in the
plains developed societies that were dependent upon the bison. Their
economies, social structure, politics and religions were based on bison. With
the advent of Europeans, firearms, railroads and a demand for hides, the
bison were hunted almost to extinction. Many of the native societies found it
difficult to adapt to a system without bison. Whaling, fishing, hunting,
agriculture based on single (or limited) crops are other examples of the
difficulty that traditionally based economies have in adapting to change.
6.1.2 COMMAND ECONOMIES
Eminent domain is the primary allocative mechanism used in a command
economy. An economic system based on command requires an agent or
organization with the authority to make allocation decisions. This authority
may be based on religion, military strength, political position, birth or wealth.
Command economies often rely on traditions as part of the allocative
process. This traditional process is subordinated to eminent domain. The
Roman society is an example of a command economy. Fascist Germany, the
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6.1.2 Command Economies
former Soviet Union and Maoist China are other examples of attempts to use
command. These economies are often thought of as “planned economies.”
During World War II many allied countries relied on command systems to
coordinate the war effort.
In both traditional and market economies command may play a significant
role. In modern, market economies there are regulations and laws that
mandate particular actions, behavior, production techniques and/or
characteristics of products.
A command economy requires an overall objective or goal for the
governing body: individuals’ goals become subordinate. Since command
economies are often represented by nation states, these can be thought of as
national goals. Some organizations act as small communities with
organizational goals and use command and eminent domain as the primary
allocative mechanism. During the medieval era, the Church and the secular
state both operated as command economies that were interrelated. In the
modern industrial world, the multinational corporation uses a command
system internally: its decisions are made administratively. Goals may include:
•
economic growth,
•
full employment,
•
industrialization,
•
military strength,
•
conquest,
•
acquisition of specie (gold/ silver),
•
land,
•
political control
•
religious conversions
•
control over markets where they sell,
•
control of resources,
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6.1.2 Command Economies
•
or any thing else that the governing authority chooses.
One of the important questions in a command economy how the overall
objective is selected. It may be an administrative choice. The authority may
simply select the objective. If this is the case, the intentions of the authority
become crucial: are they benevolent or not? In some cases, it may be possible
to have the objectives of the members of the community reflected in the
overall objective. Market socialism in the former Yugoslavia is an example.
The task of the command system is to coordinate individual behavior with
the national or organizational goal. A command system relies on
administrative decisions that flow from the authority down. This requires that
the decisions be communicated to the individuals and enforced. This may
require a complex system of rules and institutions to communicate and create
the appropriate incentives to act on that information.
The authority that is responsible for the administrative decisions that are
imposed on the members of the organization or state, must have information
about the goals, the members of the community, the availability of inputs, all
potential technologies, all alternative outputs and potential distribution
patterns. This is an enormous information requirement that was debated in
the “socialist calculation debate.”
One of the strengths of a command system is that it can alter its objectives
quickly. In a wartime economy, it may be useful to be able to command the
allocation of resources into the development and production of munitions and
military hardware.
The weakness of a command system is that the authority would need an
enormous amount of information about individuals’ preferences and the
production requirements of all goods and services. Command systems may
also be flawed by the nature of the authority that may or may not be
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6.1.2 Command Economies
benevolent. Another major problem of a command system is the loss of
individual autonomy.
6.1.3 MARKET
Market based economies depend on individual exchange contracts that
occur in the context of a social contract. An exchange contract is based on
quid pro quo, “I will give you this if you give me that! ” The nature of the
goods (include money) to be exchanged as well as the conditions and time is
clearly specified. It is necessary that both parties engage in the contract or
exchange voluntarily.
If the exchange is voluntary, the presumption is that a person would
engage in the exchange if and only if they are better off or no worse off after
the exchange. Therefore, a voluntary exchange results in Pareto
improvements and ultimately a Pareto superior solution to the allocation
problem.
Neoclassical microeconomics uses “supply and demand” as a representation
of a market. The demand function represents the behavioral patterns of the
buyers (both actual and potential) of a specific good. The supply function
represents the behavior of actual and potential sellers (producers) of a good.
The strength of market system is that is capable of quickly adapting to
changes in preferences and technology. The information required by any one
agent is minimal. The weakness is that when exchanges are not voluntary or
property rights are attenuated (weakened), outcomes may be less than
optimal.
Neoclassical microeconomics tends to be a study of contracting and
voluntary exchanges between individuals. The context in which these contracts
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6.1.3 Market
occur is usually “the market.” The structure of the markets is perceived to
influence the behavior or the individuals who participate in voluntary
exchanges or contracts.
In its most ideal form, the market is characterized as “pure competition.”
In pure competition, there are a large number of buyers and sellers, none of
which can influence the price or the behavior of others: they can only contract
to exchange goods (and money). The purely competitive market is
characterized by goods that are homogeneous: i.e. buyers perceive these
goods as identical or perfect substitutes. Buyers have no preference for one
seller’s good over another’s. The exchange or contract is made on the basis of
price. In this way, sellers compete for buyers by lowering the price to the
minimum they will accept. Buyers compete to purchase by offering the highest
price they are willing to pay. In a market such as this the equilibrium price:
the price at which the last (or marginal) unit is exchanged will optimize the
welfare of the buyers and sellers. In the least desirable market form, a seller
has a monopoly where there is only one seller of a good. The effects of market
structure on the behavior of buyers and sellers are an important topic in
neoclassical microeconomics that is covered in Part II of this text.
The social context of economic behavior is often not made explicit. People
perceive that individual exchange in competitive markets is the only
consideration. This leads to the perception that the government and
community have little or no role in economic activity. Many laissez faire
advocates fail to recognize that economic behavior is a part of social behavior.
Friedrich A. Hayek (1899-1992) is a well-known advocate of the market system.
He identifies the social infrastructure that must exist to support individual
market exchange. The following quotes are long because they are important
and must be considered in the context of Hayek’s ideas:
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6.1.3 Market
While it would be an exaggeration, it would not be altogether untrue to
say that the interpretation of the fundamental principle of liberalism as
absence of state activity rather than as a policy which deliberately
adopts competition, the market, and prices as its ordering principle and
uses the legal framework enforced by the state in order to make
competition as effective and beneficial as possible-and to supplement it
where, and only where, it cannot be made effective-is as much
responsible for the decline of competition as the active support which
governments have given directly and indirectly to the growth of
monopoly. It is the first general thesis which we shall have to consider
that competition can be made more effective and more beneficient by
certain activities of government than it would be without them. With
regard to some of these activities this has never been denied, although
people speak sometimes as if they had forgotten about them. That a
functioning market presupposes not only prevention of violence and
fraud but the protection of certain rights, such as property, and the
enforcement of contracts, is always taken for granted. Where the
traditional discussion becomes so unsatisfactory is where it is suggested
that, with the recognition of the principles of private property and
freedom of contract, which indeed every liberal must recognize, all the
issues were settled, as if the law of property and contract were given
once and for all in its final and most appropriate form, i.e., in the form
which will make the market economy work at its best. It is only after we
have agreed on these principles that the real problems begin. (Hayek,
pp 110-111)
Hayek continues:
If I am not mistaken, the main headings under which the measures
required to insure an effective competitive order ought to be considered
are the law of property and contract, of corporations and associations,
including, in particular, trade-unions, the problems of how to deal with
those monopolies or quasi-monopolistic positions which would remain in
a otherwise sensibly drawn-up framework, the problems of taxation, and
th problems of international trade, particularly, in our time, of the
relations between free and planned economies.
As far as the great field of the law of property and contract are
concerned, we must, as I have already emphasized, above all be aware
of the error that the formulas of “private property” and “freedom of
contract” solve our problems. They are not adequate answers because
their meaning is ambiguous. Our problems begin when we ask what
ought to be the contents of property rights, what contracts should be
enforceable, and how contracts should be interpreted or, rather, what
standard forms of contract should be read into the informal agreements
of everyday transactions. (Hayek, pp 112-113)
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6.1.3 Market
Adam Smith also saw a positive role for government. As implied in the
quotes from Hayek, it is the content of the laws of property and contract that
is crucial. It is important to identify the role of the state in structuring the
allocative process that society depends upon.
6.1.4 ROLE OF GOVERNMENT
One of the major controversies is the proper role of government (and the
use of command) within a market based economic system. Many of the issues
in this controversy are ideological in nature and result in the existence of
different “schools of economic thought.” The Chicago School and the Austrian
School of economic thought argue that the role of government in the economy
should be minimized. (Hayek taught at the University of Chicago and was an
Austrian economist.) The American or “Old” Institutionalists and much of
Neoclassical microeconomics (in the Cambridge tradition) sees a more positive
or active role for government in many areas.
The French Physiocrats [led by Francios Quesnay, 1694-1774] advocated a
minimal role for government. Jacques Claude Vincent de Gournay [1712-1759]
is usually credited with the phrase laissez faire, laissez-passer! Some
advocates of an extreme laissez faire doctrine argue that there is no or almost
no role for government. Most argue for limited government action in the
economy. Others, such as Adam Smith and F. A Hayek (above) see a positive
role for social institutions and government participation. Adam Smith [1723-
1790], who was familiar with the work of the Physiocrats, advocated a social
system based on ethics, markets and jurisprudence with a minimal role for
government.
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6.1.4 Role of Government
There are many arguments about the proper role of gov