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Informal institutions as inhibitors of rent-seeking entrepreneurship: evidence from U.S. legal history

Journal: Entrepreneurship Theory and Practice

Date: 2023

Author: Andrew Smith, Graham Brownlow

Abstract:
Rent-seeking entrepreneurship occurs whenever an entrepreneur expends resources on activities that benefit their firm while reducing overall economic efficiency. Since rent-seeking ultimately makes nations poorer, we need to know more about how institutions can discourage rent-seeking entrepreneurship. Using historical data from the Unites States, we explore how changes in judicial thinking altered individuals’ incentives to engage in rent-seeking entrepreneurship. Traditionally, entrepreneurship researchers interested in policy issues have paid little attention to changes in judicial thinking. We argue that entrepreneurship researchers who are interested in why levels of entrepreneurial dynamism vary over time should pay more attention to how judges think.

Link: Google Scholar

Background and Context

Understanding Rent-Seeking Entrepreneurship

Rent-seeking entrepreneurship occurs when entrepreneurs expend resources on activities that benefit their firm while reducing overall economic efficiency.

Research Approach

Using historical data from U.S. legal history, the authors examined 52 court cases to explore how changes in judicial thinking altered incentives for rent-seeking entrepreneurship.

Focus on Informal Institutions

The study investigates how norms, beliefs, and informal institutions shaped judicial decision-making and moderated the effectiveness of formal institutions in discouraging rent-seeking.

Evolution of Judicial Restraints on Rent-Seeking (1791-1940)

Pre-1868 Limited Restraints 1868-1915 Strong Restraints 1915-1937 Weakening Restraints Post-1937 No Restraints 14th Amendment (1868) Lochner Decision (1905) West Coast Hotel (1937)
  • During the "Lochner Era" (1868-1937), judges actively struck down regulations that limited economic freedom.
  • The 1937 Supreme Court decision (West Coast Hotel case) marked a pivotal shift away from restraining rent-seeking.
  • The effectiveness of constitutional constraints on rent-seeking varied dramatically across these historical periods.

Five Key Norms That Influenced Judicial Decisions on Rent-Seeking

Freedom to Manage No-Bailouts Principle Freedom of Contract Public Utility Exception Ethno-Racial Bias Anti-Rent Seeking Norms Pro-Rent Seeking Norms Strong pre-1915 Strong post-1915
  • Three norms discouraged rent-seeking: freedom to manage, no-bailouts principle, and freedom of contract.
  • Two norms legitimized rent-seeking: public utility exception and ethno-racial bias exception.
  • The relative strength of these norms shifted dramatically after 1915, changing judicial interpretation.

Dramatic Increase in Regulation Volume After 1937 Decision

1940 1960 1980 2000 2010 2020 Years Volume of Regulations 1937 Decision
  • The number of pages in the Code of Federal Regulations increased from 10,000 in 1950 to 180,000 in 2019.
  • After courts ceased invalidating regulatory interventions in 1937, regulations proliferated dramatically over subsequent decades.
  • This growth in regulation created more opportunities for rent-seeking entrepreneurship and reduced economic dynamism.

Interaction Between Formal and Informal Institutions Shapes Entrepreneurial Behavior

Formal Institutions Constitution, Laws Informal Institutions Judicial Norms Entrepreneurial Behavior Rent-Seeking vs. Productive ×
  • The Constitution alone couldn't prevent rent-seeking; judicial interpretation of the text was critical.
  • Formal institutions (laws) interacted with informal institutions (norms) to shape entrepreneurial incentives.
  • The shift in judicial philosophy changed what entrepreneurs could get away with despite unchanged constitutional text.

How the 1937 Decision Reversed Entrepreneurial Incentives

Pre-1937 Post-1937 Productive High Incentive Rent-Seeking Low Incentive Productive Lower Incentive Rent-Seeking High Incentive
  • Before 1937, courts created a "chilling effect" on rent-seeking and encouraged productive entrepreneurship.
  • After 1937, the incentive structure flipped, making rent-seeking through regulation more attractive.
  • This period of limited rent-seeking (1868-1937) coincided with rapid economic and technological progress.

Contribution and Implications

  • Entrepreneurship scholars should pay more attention to judicial thinking when studying variations in entrepreneurial dynamism.
  • War and militarism may encourage judges to accept greater government control, enabling more rent-seeking.
  • Even with intact formal institutions like the Constitution, changing informal institutions can dramatically alter entrepreneurial incentives.
  • The study reveals how intellectuals indirectly influence policy environments by shaping judicial thinking.
  • Racial and ethnic prejudice often serves to legitimize forms of rent-seeking at society's expense.

Data Sources

  • Visualization 1: Based on the authors' analysis of key periods identified in the historical analysis.
  • Visualization 2: Based on Table 1 in the article showing the five norms that influenced judicial decisions.
  • Visualization 3: Based on data cited from George Washington University's Regulatory Studies Center (2020).
  • Visualization 4: Based on the authors' conceptual framework of institutional influences described in the paper.
  • Visualization 5: Based on the authors' analysis of changing entrepreneurial incentives across historical periods.