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of production and transaction costs. They will trade off agency costs against the resource costs of preventing agency problems.

In an administrative bureaucracy, where bureaucrats receive a small share of the benefits and costs of their decisions, the state will impose regulatory constraints on decisions and monitor results in order to prevent deviation from centrally set goals.

In the Russian bureaucracy, both principals and agents have incentives to seek arrangements that give them control of information influencing the division of income. For example, low-cost producers will seek to conceal their true profits in order to retain a larger share, while government principals may seek to hide the true value of centralized resource rents from both enterprises and regional authorities who enjoy some de facto control rights to local resources. Since agents have incentives to divert resources from joint activities to their separate benefit, the authorities will attempt to create strong restrictions to local initiative.

Moreover, if the political elite, as principals, gain security by their ability to monitor decision makers at lower levels in the hierarchy to prevent challenges to their authority, the state system will not necessarily have incentives to reduce monitoring costs, either. With collusion, there will also be costs of monitoring the monitors. So in sum, state-owned institutions burden citizens with an inefficient partitioning of property rights and deny them governance mechanisms that would allow them to contract around inefficiencies.

The Role of Property Rights

The success of an economic system depends on how its institutions structure the incentives to produce wealth, to capture wealth, and to protect wealth. Property rights are a key institution in this process. Property rights are rules of the game that may be defined by formal laws or administrative practices or may be codified in informal custom. They define the forms competition for resources may take in society.

Consider two individuals, A (with an endowment of wine) and B (with an endowment of cheese). What institutional arrangements would allow both individuals to consume both commodities? The form of the transfers from one party to another will depend, in part, on whether each individual respects the other's property rights. If property rights were not protected, A could steal B's cheese, transferring ownership without compensation. If B has to incur high costs to protect herself from theft, then the value of her property will be much reduced. Alternatively, A could threaten B with violence. In this case, A would have transferred property rights to B's person, but he would allow B to purchase the rights back with an appropriate amount of cheese. Voluntary market exchange will occur only if each individual recognizes the other's property rights. (For systems with private



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