Formula Elaboration # 1: Rules

In our introductory post, we set forth the basic formula that expresses the idea of this website:

Rules x Action in the Face of Uncertainty x Interactions of Individuals = Complex and Perpetually Novel Outcomes

Today we begin a brief series of elaboration designed to explain just what we mean by the elements in this formula. Let's start with Rules, or (R) for short. 

(As will become clear, the elements--and anything additional we will later include--are arranged not in chronological order, but in order of what we perceive to be importance in their contribution to the product. That is, we don't think that, when a market economy begins, a council of elders sits down and designs a given set of rules, just as the evolution of baseball doesn't trace itself to a single inventive point in time when someone sat down and made up rules for a never-before-seen game. This is a chicken-and-egg issue and really isn't relevant here.)

Rules are relatively straightforward. Clear rules, both formal and informal, govern a baseball game. Formal rules include foul lines, base paths, the strike zone, the pitching rubber, etc. These provide the basic playing template for the game and are for the most part unchanging. (Critics of the possibly-shrinking strike zone would disagree.) 

The formal rules provide a measure of certainty and are undergirded by informal rules: when a pitcher can knock down a batter, discouragement of stealing bases in late innings when ahead by so many runs, how hard to take out the shortstop during a double play, etc. Tacit and unwritten, informal rules nonetheless help shape the contours of the game.

Market economies are to a great extent self-generating and self-regulating, yet no market economy can function without clear rules and standards. As Financial Times commentator Martin Wolf has written: "Good markets need good governments." Government regulation is, by nature, reactive, but plays a crucial role in structuring economic processes. 

Rules promulgated by government, however, by no means exhaust the rules that provide structure in a market economy. Any type of human behavior occurs in a structure of formal and informal rules. Statutory laws, municipal codes, and accounting standards (often non-governmental) are examples of formal rules. Informal rules can be identified for almost any type of situation: table manners, linguistic conventions, behavioral norms, etc. These can often be unconscious, but still influence our actions. The emphasis within many corporations on "tacit knowledge" is another good example.

Nobel laureate in economics Douglass North is perhaps the most famous name associated with this distinction between different types of rules: he pioneered much of the work, known as new institutional economics, in illuminating the rule structure in which market behavior occurs. Likewise, for a slightly unorthodox but enlightening take on different levels of behavior in the context of economic change, see the work of Geoffrey Hodgson.

No baseball game could be played and no economy could function without rules. But even if you memorized the entire rule book for Major League Baseball, you would have only the dimmest idea of what actually goes on during a game and what determines the outcome of each game. The same goes for the economy: laws and regulations and informal behavioral norms shape economic behavior, but don't really tell you what goes on or how things change.

I suppose this is slightly analogous to the idea that "creativity loves constraints," and you can already see this adumbrating the product (complex and perpetually novel outcomes), but be patient. We next explore the other parts of the formula.