Property Rights and Growth

A first look at Douglass North and Robert Thomas, The Rise of the Western World: A New Economic History (Cambridge, 1973)

We know the difference between the cause of an illness and the illness itself. We recognize the flu by its symptoms, but we know that the cause of the flu is a virus. North and Thomas argue that we are less careful about distinguishing the causes of growth from growth itself. Capital accumulation and technological progress, for example, are not causes of growth: they are “symptoms” of growth. We must look beneath the surface of growth to find its causes.

Property Rights

North and Thomas argue that the establishment and enforcement of property rights has been a major cause of economic growth. A person who has property rights over a particular resource has the right to control it and use it as he pleases. Property rights are determined in part by law and in part by social conventions.

Both of these factors affect the acceptability of smoking in public places, which is essentially a question of who has property rights over the air we breathe. Is it the smoker, or the people around the smoker? In the middle of the twentieth century, social convention gave the property rights to the smoker. If you watch an old Humphrey Bogart movie, you will see that people smoked in restaurants, taxis, and other people’s homes. They might ask for permission to smoke, but that permission was never refused. Everyone understood that smokers had the right to smoke, and if your curtains stunk at the end of the evening, that was just the cost of hospitality. The assignment of property rights began to change in the last decades of the century. At first non-smokers began, with some embarrassment, to refuse their guests permission to smoke in their homes. Then the movement spread to restaurants: people began to complain of smokers at nearby tables. Governments eventually stepped in, banning smoking in restaurants, airplanes, taxis, public buildings and then (the final hurdle) in bars. By the end of the century, the property rights over the air we breathe were firmly held by non-smokers. Social convention dictated this assignment, and the law backed it up.

Rosemary Williams, showgirl, photograph by Stanley Kubrick
Rosemary Williams, showgirl, photograph by Stanley Kubrick

Right Action

A clear assignment of property rights is generally necessary for the efficient use of a resource. To understand why, we need some basic concepts from economics, namely private and social costs and private and social benefits. The private cost of an action is the cost that is incurred by the person who initiates the action, while the social cost is the cost that is incurred by society as a whole (the initiator plus everyone else). Likewise, the private benefit of an action is the benefit that accrues to the initiator, while the social benefit is the benefit that accrues to society as a whole. The individual decides whether to undertake an action by comparing its private benefit to its private cost. If the private benefit exceeds the private cost, he undertakes the action; if the private cost exceeds the private benefit, he abstains from the action. The action’s impact on society is found by comparing its social benefit to its social cost. An individual benefits society when he undertakes an action whose social benefit exceeds its social cost, but he harms society when he undertakes an action whose social cost exceeds its social benefit.

Economists tend to believe that, for most goods at most times, the social and private costs are equal, and so are the private and social benefits. Under these circumstances the actions taken by private individuals will advance society’s interests:

  • If the private benefit is greater than the private cost, the action makes the individual better off and he will undertake it. Since the social benefit is also greater than the social cost, this action also makes society better off. From society’s perspective, the individual is doing the right thing.
  • If the private benefit is less than the private cost, the individual recognizes that the action would harm him, and chooses not to undertake it. Since the social benefit of the action is less than its social cost, society would not want the action undertaken, and so it is again content with the individual’s decision.

Individuals pursuing their own selfish ends are then advancing society’s welfare, just as Adam Smith had suggested in The Wealth of Nations:

He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.1

It is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from their regard to their own self-interest.2

We expect social and private valuations to match up not just for meat, beer and bread, but for automobile tires and kitchen chairs and thousands of goods that we routinely exchange in the marketplace. But they do not always match up, and when they don’t, the individual’s decisions are not necessarily in society’s interests. Here are two examples of this possibility.

Environmental pollution is a situation in which the social and private evaluations are not equal. For example, firms might release toxic chemicals into the air or water because it is a cheap method of disposal. The private cost of this method of disposal is low, but the social cost includes its impact upon the people living nearby. Their quality of life is lower, and they might experience ill-health: the toxins might even kill them. This mismatch between the private and social costs makes this situation very likely:

SC > SB = PB > PC

The firm releases the toxic chemicals because this action makes it better off (PB > PC), but the firm’s action is harmful to society (SC > SB).

A mismatch between private and social evaluations could also cause an individual to refrain from an action that would be beneficial to society. Consider, for example, the decision to be inoculated against some infectious disease. An individual who chooses to be inoculated protects his own health, but he also incurs costs in the form of lost time and nuisance. He might judge the protection to be worth less than these costs, and decide not to be inoculated. However, a person’s decision to be inoculated protects other members of the community as well as himself. Infectious diseases can only establish themselves if there is a large population of susceptible people. An individual who chooses to be inoculated reduces the susceptible population by one, making everyone who is not inoculated just a little bit safer. Since the social benefit of inoculation is greater than the private benefit, the following configuration is possible:

SB > SC = PC > PB

The individual chooses not to be inoculated, but society as a whole would be better off if he were inoculated.

Property Rights in History

The argument that North and Thomas make is that the ultimate cause of the western world’s economic growth was the gradual establishment and enforcement of property rights, which reduced the gap between social and private valuations. The diminished gap induced individuals to take actions that benefited society as a whole, and dissuaded them from taking actions that harmed it. Here are a couple of examples of this process.

The fundamental economic institution of the early middle ages was the manor, an extended agricultural enterprise. Crops were raised and livestock grazed on cleared land. Timber, stone and game were taken from the adjacent forests. The manor’s roads and buildings were constructed by the people of the manor, who also plowed and planted and harvested the fields, milled the grain into flour and baked the flour into bread, spun wool into yarn and wove the yarn into cloth. Almost every material need was satisfied from within the manor, and almost all of this work was done by serfs who were legally bound to the manor. The serf had both rights and obligations. He was entitled to work specific strips of land, from which he was expected to provide food for himself and his family. His children would be serfs in their turn, and his sons would inherit the right to work the land that their father had worked. But he was only allowed to work this land on specified days; on the remaining days, he was required to work the lands of the manor lord. The manor lord had been granted the rights to the manor by a superior, perhaps the king, and was expected to exploit it for his personal gain. The manor lord lived fairly well (for the times); the serfs survived.

The serf lacked property rights over his own labour. On the days that he worked for the lord, his tasks were assigned to him and he received no compensation. On the days that he worked for his own benefit, he had no choice but to work the lands assigned to him. He could not leave this manor to search for another where he would be better treated, and he could not leave it to take up some other kind of work. This system guaranteed that a great deal of his labour was wasted. The serf’s incentive while working for the lord was to conserve his energy, the better to work his own land when the time came. On the days that he did work his own land, it was his only choice. There might well have been more productive things that he could do (work better land, or adopt a new trade) but he was legally prohibited from taking these options. In short the private benefit of his labour was a fraction of the social benefit.

The eventual collapse of the feudal system, and the appearance of markets in which land and labour were freely traded, gave people property rights over their own labour. A farm labourer could rent land at a known price and then manage his own labour; or he could freely contract to work for someone else, knowing that the sooner this job was done, the sooner he could take on another. In either case shirking would harm only himself, and all of the rewards of harder work would accrue to himself. The private benefit of labour was then very much greater, perhaps even as large as its social benefit. The decisions made by labourers were likely to be in society’s interests as well as his own.

The medieval norm of absolute rulers also meant that no-one had well-established property rights. The king could impose taxes as he saw fit, or expropriate all of a person’s property, or even kill him as a prelude to expropriating his property. People responded to this environment by not acquiring the kind of wealth that would make them a likely target, and by hiding their wealth when they did acquire it. They also invested heavily in remaining in the king’s favour, or if the king looked weak, in the favour of whoever looked likely to oust him. None of these actions constitute, from the perspective of the society as a whole, good investment decisions. Restricting the power of the ruler was therefore an essential step in securing property rights for the people. North and Thomas show that the countries that successfully constrained their rulers (England and the Netherlands) became the economic leaders of western Europe, while those that were unsuccessful (Spain and France) fell behind.

Property Rights in the Modern World

North and Thomas focus on European economic history, but their belief that property rights are a prerequisite of economic growth can be tested by looking at places in the modern world where they are absent or poorly enforced. Two of these places are Africa, which remains underdeveloped despite massive infusions of foreign aid, and Russia, whose transition from central planning to free markets produced decades of chaos.

Robert Calderisi worked for the World Bank and other development agencies in the last quarter of the twentieth century, and much of that time was spent in Africa. He describes his experiences in The Trouble with Africa and although he does not use the term, it is clear that much of Africa’s trouble has to do with property rights.

European property rights developed by limiting the power of monarchs, first by restricting their ability to tax or expropriate the property of the citizens, and then by developing democratic institutions that reduced the monarchs to little more than well-dressed ribbon cutters. Calderisi found that this process had barely begun in Africa. Rulers often made little distinction between the state’s property and their own, with the result that many of them grew fabulously wealthy even as the citizens lacked such fundamental amenities as sanitation and clean water. They were not apologetic about their behaviour. (A president of Gabon asked a French journalist, “Was the palace at Versailles built with money belonging to the French state or to Louis XIV?”) Their greed was coupled with a determination to override democratic institutions, so that some of them were able to remain in power for decades.

Corruption was endemic in the African economies, from government ministries down to schoolteachers and policemen. Every bribe reduces the entrepreneur’s return and inhibits economic growth, but Calderisi observes that even the poor are subject to predation. A schoolteacher accepts “tips” from parents who want their children to have seats at the front of large classrooms. A man with a broken arm needs a letter from his doctor certifying that he is unable to work; his doctor charges him two weeks’ pay for the letter.

Africa’s tradition of extended families also serves to erode property rights. A person who is moderately successful will find that even very distant relatives expect his financial help. His inability to retain the full rewards of his labour reduces his incentive to work. Calderisi also suggests that the extended family goes some way to explaining the culture of corruption. A government official might find himself responsible for the welfare of a great many people. If his salary is not enough to support them, supplementing his income through “tips” is an attractive option.

Russia abandoned central planning for free markets shortly after the election of Boris Yeltsin as Russia’s first president in 1991. About 225,000 state-owned firms were privatized, state subsidies were ended, and trade was liberalized. Prices were no longer determined by fiat, but allowed to rise to clear the markets. The graph below shows the impact on Russia’s per capita income: it collapsed and took a decade to recover.3

The institutional underpinnings of a market economy were missing. A dispute between firms under central planning had been an administrative matter: the firms were state agencies so only the state’s interests were at stake, and the matter could be settled in whatever fashion best served the state. A dispute between firms under free markets is a judicial matter: the firms’ interests are separate and competing, and a judge must choose between them. This kind of decision requires property law and contract law that had not existed under central planning. As well, not many people understood competition. The people who did were the ones who had been engaged in the black market and other illegal activities, and they had developed their own extra-judicial means of resolving their disputes. These factors meant that property rights were not well protected.

Jordan Gans-Morse describes the 1990s in this way:

In the absence of effective state institutions, firms turned to alternative forms of protecting property and enforcing contracts. Criminal protection rackets and private security agencies provided physical protection, collected debts, and adjudicated disputes among firms. When large sums of money were at stake, contract killings became a prominent means of acquiring or protecting assets. In short, outright force and the threat of physical coercion became common tools for protecting property and ensuring adherence to business agreements.4

Russia became the Wild West for a time, but by 2000, firms were increasingly relying on the courts to resolve disputes. Firms also used lawyers and private arbitrators to settle disputes before they reached the courts. Physical coercion had become much less common. Property rights were still not secure, though, because another actor had arisen to threaten them: the state. According to Gans-Morse, firms now face threats that include

(1) attacks by high-level officials, (2) attacks by lower-level state officials acting on behalf of paying private-sector clients, and (3) attacks initiated directly by lower-level state officials, such as regulators and law enforcement agents. Attacks by state actors on property rights manifest in many forms, such as the seizure of firms’ assets, facilitation of illegal corporate raiding, extortion, illicit fines, and unlawful arrests of businesspeople.

These threats, too, are increasingly being brought before the courts. Russia is on the path to enforceable property rights, but is not there yet.

Conclusions

There is in the West a fairly broad agreement that markets are the best way to allocate resources, and that the state should intervene only when there is a clear mismatch between private and social evaluations (as is the case, for example, with environmental pollution). Property rights that are well-defined, and enforceable in a court of law, are an essential but often invisible underpinning of this system. It is property rights that eliminate, as often as possible, the gap between social and private evaluations.


  1. Adam Smith, The Wealth of Nations, Book IV, Chapter 2.
  2. Adam Smith, The Wealth of Nations, Book I, Chapter 2.
  3. Note that this graph is log-linear, so that a steeper (flatter) line corresponds to a faster (slower) growth rate. Per capita income is measured in “purchasing power parity U.S. dollars” to remove the impact of rouble depreciation.
  4. Jordan Gans-Morse, “Threats to property rights in Russia: from private coercion to state aggression”, Post-Soviet Affairs (2012).