[SOUND]. We've just argued that an important function of government is to align incentives of economic agents, so that private benefits would be consistent with social gains and not opposed to them. The government can achieve this outcome by using various tool, in particular, by using laws and regulations. And we saw how this alignment can be accomplished in the case of contract enforcement by making sure that courts enact and enforce appropriate damages paid by contractors in case contracts are breached. So, special mechanisms of contract enforcement maintained by government align incentives of the private parties in this particular case of contractors with those of social interest. Now let me give you another illustration of the same very important, critical important role of the government. And in this case government's presence affects individual choices between different types of economic activities. Some of you might have heard that activities in modern economies can very crudely be divided between different groups and types, different clusters. And I should say right away that the border line, the separation line between these two clusters that I have in mind is not always very clear. Sometimes, oftentimes, it might be quite blurred. But I'm talking about what is known as productive activities and rent-seeking. A very general definition of productive activity is that this is an activity where an economic agent and individual who is engaged in this activity benefits from it. She's better off because she's engaged in this activity. But so is the society. In other words, productive activities benefits individuals that carry out such activities. And the society simultaneously at once. The society and an individual are better off jointly as a result of this individual's engagement in productive activities. Speaking metaphorically, productive activity is such that it increases social wealth. And this increase in part or fully is captured by the individual which is engaged in such activity. As opposed to productive activities, rent-seeking is something which is still individually rational. An individual who is engaged in rent-seeking is still better off because of that engagement, but the society is not better off. In fact, the society oftentimes is worse off as a result of an individual's engagement in rent-seeking simply because rent-seeking does not create new wealth, does not create new value. An individual is better off simply because she redistributes to herself a part of the wealth or a part of the value that was already in the society. You can argue that productive activities are a positive-sum game whereas rent-seeking, at best, is a zero-sum game. Oftentimes rent-seeking is a negative-sum game. It is a negative-sum game simply because rent-seeking suppresses incentives of the individuals who would like to be engaged in productive activities from such engagement because such individuals are suspect that some of the return, some of the payoffs to their productive activities will be taken away from them by rent-seekers. So, the damage of rent-seeking to the society is two-fold. First of all, the society suffers because some resources are redeployed from productive use to rent-seeking. It suffers furthermore because it reduces the incentives of individuals who would like to be engaged in productive activities, to do so. Rent-seeking and productive activities are, perhaps, the clearest case when individual rationality and social needs are dramatically opposite to each other. And, therefore, it's paramount for good governments to redirect human resources and other resources which exist in the economy from rent-seeking to productive activities. Now the important thing to keep in mind is that resources which are available to the economy are most of the time multi-purpose resources and this is certainly the case with human resources. Individual decide in which areas of economy to operate, what careers, what jobs, what functions, and so forth to choose for themselves, depending on the anticipated payoffs, and it's very important that individuals while making these choices give preference to productive activities versus rent-seeking because, from what I told you so far, it's easy for you to realize that societies and economies where rent-seeking reigns supreme where many individuals are engaged in rent-seeking it should be a very poor economy because very little is produced in such economies. And much of the energy that exists is directed, is targeted toward redistribution rather than to production. Vice versa, if there is an economy where all of the energy, talent, entrepreneurship, time, effort, and so forth are contributed to productive activities, in such economies we should expect a lot of prosperity. And this is a very common theme in modern literature, and the famous american economist William Baumol illustrated the choice of individuals of areas of activities between productive activities and rent-seeking very clearly and very vividly by comparative analysis of patterns observed in histories of different countries around the world. If you look back into the history, you see certain periods of time in certain countries features literal explosions of entrepreneurial activities. Industrial Revolution in the West, late 19th century in the United States, modern China, you name it, you see times and periods where lots and lots of people are engaged as entrepreneurs and, as a result, quite clearly they advance economic development. On the other hand, in some countries in some periods of history you see almost no entrepreneurship. It's heavily suppressed. You see no innovations. You see no new markets. You see no new technologies. You see no new ideas. You see none of that. So, how could you explain this differences asks Baumol and answers: well, it's not necessarily because there are fewer potential entrepreneurs in country A in one period of time than country B at, perhaps, another period of time, it's simply because the conditions in these countries are different. It's simply because government policies in these countries are different. In country A, where we see a lot of entrepreneurship, governments protect property rights. Governments provide enabling conditions for private enterprise. And, as a result, people with imagination, with energy, with vision, people who are willing to take risks, in other words, would be entrepreneurs, become entrepreneurs in the productive sense of the word. Whereas in other countries, the very same people, people who have creativity, energy, vision, daring individuals, risk-taking individuals will contribute all of these qualities, all of these resources towards rent-seeking. And they will be searching for different ways to do well, to enrich themselves not by contributing to society but by successfully, more successful than others, taking away from the society by coming up with different ideas and means as to how to navigate through confused regulation, as to how successfully lobby government, as to how to be involved in frauds which are, perhaps, on the other side of the law but because law enforcement is weak, people can get away with this, so on and so forth. So, according to Baumol entrepreneurs are among us all the time in all countries but the difference is to which areas of activities entrepreneurs contribute their outstanding skills and qualities. And this is the choice between rent-seeking and productive activities. And, of course, this choice depends on the quality of government institutions, on the strength of government. It depends first and foremost on how strong the governments protect property rights. Property rights protection is one of the main functions of governments. So, let me give you a very simple illustration which shows how the degree of property rights protection affects individual's choices between production and rent-seeking. And how, as a result, it contributes to the wealth of nations. This inequality compares outcomes, payoffs, of an individual's engagement in productive activities or in rent-seeking where the number of people who already engage in production is x. And, as you can see, depending on what the government does, and the level of property rights protection theta is, in fact, the government's choice variable, it's the government's choice variable, these payoffs look differently. If property rights are better protected, then production become relatively more attractive than rent-seeking. Still, we should expect that if theta is between zero and one, there will always be some people engaged in production, and in rent-seeking but what matters is the proportion, is the number of people who are engaged in productive activities. And this proportion characterizes an equilibrium, and this equilibrium, in its turn, depends on how effectively the government does its job. And this equilibrium itself affects the wealth of this economy. Let me illustrate to you this equilibrium by a simple diagram. At the bottom graph, I see this curve which is the graph of the production function. And as you see, it does exhibit decreasing returns to scale. The total wealth of this society depends on x and the greater is the number of people who are in engaged in production, the wealthier this society is. So, quite obviously, social optimum is achieved when x equals 1 and in that case total gains are F(1). Now, piracy and chemical engineering in this case are two alternative activities. And although we respect chemical engineering much more than piracy, we respect productive efforts more than rent-seeking, what we're concerned about at this time is the net gains, is the total benefits that economic agents accrue in different equilibria. And these net gains, as I said, depend very strongly on government policies. Let's consider a particular level of property rights protection theta. And in this case the payoffs to production will be theta F'(x). And this is indeed a declining curve, it's a negatively sloped curve. The payoff to rent-seeking will be 1 minus theta F of x on 1 minus x. And it's easy to verify that this is a positively sloped curve. And these two curves intersect in this particular point and this is the equilibrium. In this equilibrium, the level of production is x, and the society's welfare is F(x). Now, suppose that the protection of property rights for some reason is deteriorated, and that will lead to the movement of this curve to the left according to this arrow. And because theta is getting smaller (to the left or down, which is the same thing here), theta is getting smaller, and, as a result, this curve, which describes payoffs to rent-seeking is moving upward or also to the left. So, the equilibrium used to be here and now the equilibrium is here. And we see that this equilibrium level of involvement in production is much smaller. A larger proportion of people are involved in piracy and much smaller in production, and as a result, the new equilibrium level will make the society quite a bit poorer. In this equilibrium, the government is doing much better than in this one, and as a result, in this equilibrium the economy is considerably more prosperous than in this one. And again this is a good illustration how economic development, economic conditions depend on the quality of government, and it's also a good illustration that an important role of government is to affect private sector conditions in a way that align individual incentives with social welfare. When property rights are well protected, capable individuals will do much better in production than in rent-seeking. And production is something that is in the interest of the society. When property rights are poorly protected, when the government is failing on this very important count, then capable individuals will do a lot better in rent-seeking than in production activities. And in this case, individual rationality is far apart from social optimality, from social welfare. [SOUND]
