Law & Order: Bottom-Up or Top-Down? The Rules of Capitalism, Part 4

In continuing my analogy between sports and society and the necessity of rules, if governing bodies make the rules for sporting events, who makes the rules for society? Institutions. Institutions generate both the informal social norms and the formal legal rules that govern individual behavior and structure interactions between individuals in social situations.

The Washington University economist Douglass North, who nabbed a Nobel for his pioneering research on the relationships between institutions and economics (a field now called Institutional Economics), outlined two general types of institutions, informal and formal. Informal institutions are structures such as traditions, customs, and values. These are bottom-up, self-organized institutions that evolve slowly and change when nudged by cultural trends and shifting traditions. Formal institutions are rules and laws that are intentionally designed from the top-down, such as constitutions and legal codes, and for which change typically comes about only disruptively through new legislation or, when legal means are ineffective, through wars and revolutions. In keeping with my sports analogue, North notes in his Nobel prize speech, “If institutions are the rules of the game, organizations and their entrepreneurs are the players.” Organizations, for example, are bound by a common goal and include “political bodies (political parties, the Senate, a city council, regulatory bodies), economic bodies (firms, trade unions, family farms, cooperatives), social bodies (churches, clubs, athletic associations), educational bodies (schools, universities, vocational training centers).”

The transition from informal to formal institutions enables the transition from personal to impersonal exchange; that is, from trade between family and friends in small communities to trade between strangers and foreigners in large societies. Examples abound.

In the wild west of the American frontier, before the long arm of the law could reach that far from Washington, D.C., property rights were established and enforced through such informal institutions as land clubs, mining districts, and cattlemen’s associations. Squatters who believed that possession was nine-tenths of the law set up land clubs to justify their settlements and enforce ownership of their newly acquired land before the government did it more formally with the Homestead Act. Miners did something similar by setting up mining districts and clubs to run them, thereby setting up informal rules that later evolved into public mining law. Cattlemen branded the hindquarters of their calves as a literal stamp of ownership, a rule enforced through informal cattle associations that endorsed the employment of hired gunmen as a prelude to a whole suite of laws later passed to do the same thing formally.

A more recent example of the transition from informal to formal institutions can be seen in the shift from “open range” laws that governed cattle ranching in Shasta County, California to “closed range” ordinances in sub regions of the county starting in 1945. In the open range system ranchers were not legally liable for damages when their cattle wandered across unfenced land onto other ranchers’ property. In 1945 a new California law authorized the application of a closed range ordinance that made ranchers liable for damages to other ranchers caused by their livestock. And yet, a study by the economist Robert Ellikson (published in his 1991 book Order Without Law: How Neighbors Settle Disputes) of what Shasta County ranchers actually did before the law was passed—instead of what economic and legal theory predicted that they should do—found that under the informal institutions set up by the ranchers themselves, “neighbors in fact are strongly inclined to cooperate, but they achieve cooperative outcomes not by bargaining from legally established entitlements, as the parable supposes, but rather developing and enforcing adaptive norms of neighborliness that trump formal legal arrangements.” Like most bottom-up self-organized systems, the informal ranching institutional rules trumped the formal legal institutional laws established to govern the activities of ranchers, and the result was “coordination to mutual advantage without supervision by the state.”

The reason that the informal institution in this case worked better than the formal is that ranchers are intimately knowledgeable about their livestock, land, and business, whereas judges, attorneys, and insurance adjustors are not. Under the informal system, rules developed whereby ranchers would notify each other when an animal strayed, if there were damages they were resolved through barter and reciprocity, and violators of the informal system were dealt with through gossip and shunning.

A similar study published in the Journal of Law and Economics by the economist Ronald Coase entitled “The Lighthouse in Economics,” demonstrated that it is not necessary for the government to install formal legal controls over “public good” in order to solve the problem of free riding (where people who do not pay for the services benefit nonetheless and at the higher expense of those who do pay for it). In the case of privately held lighthouses, the public good problem was a chimera. Coase showed that lighthouse owners contracted with port authorities to collect fees from arriving ships at portside before loading or unloading their cargo, thereby solving the free riding problem through bottom-up informal rules rather than top-down formal laws.

The rub is in finding the balance between informal and formal institutions. The former are fluid and flexible and easy to change, the latter are not. Once formal institutions are established they are difficult to disestablish. They are sticky. They build up momentum. They become self-perpetuating. Discretionary monies used to set up a formal institution soon become set in budgetary stone. People’s jobs are at stake. Livelihoods are on the line. What was once superfluous becomes indispensable. Clearly we need some formal institutions, but we must be prudent in our judgments about when, where, and how often we need to push informal rules into formal laws.