Whereas goods and services can be exchanged through bilateral transactions, political outcomes typically require collective agreement. For example, legislation typically requires the approval of a majority of the legislature. Rent-seeking models often depict rent-seeking as a contest in which the rent goes to the highest bidder. In the actual political marketplace, there are not rents that are available to bidders, and rarely is there a single contact point through which rent-seekers can bid for and be awarded rents. Government activity is initiated by some demand for access to government power. This chapter explains the interactions between suppliers and demanders for access to government power and analyzes the institutions within which the negotiating process produces public policies.

Public policy is designed in a marketplace in which policymakers and well-connected interest groups negotiate with each other. This is more than an analogy. There is an actual marketplace in which legislators exchange votes and other favors, and lobbyists and interest groups offer legislators benefits in exchange for supporting programs and policies they favor. The good that is supplied in the political marketplace is access to government power. An important characteristic of the political marketplace is that only a small subset of the population is able to participate in it. Most people face high transaction costs that exclude them from being able to participate in the political marketplace. The political elite engage in politics as exchange, while most people are unable to transact in the political bargaining process.

One check on the abuse of power by the political elite is the ability of people to move away from those who abuse their power. In agricultural societies, this is difficult to do because individuals who move must leave their land behind. Land is not mobile. One result of the Industrial Revolution was that capital displaced land as the most significant factor of production, and capital is more mobile than land. The mobility of physical and human capital has constrained the abuse of authority and has contributed to the shift from feudal political institutions toward democracy.

Institutions of organization are designed to lower transaction costs. Transaction costs tend to be prohibitively high when large numbers of people would be required to engage in a transaction, so those transactions will not occur. Classic cases of externalities, such as when large numbers of people in an area suffer from air pollution from nearby industries, are good examples. Large numbers prevent those suffering from pollution from negotiating with those who are causing it. One way that market institutions deal with the problem of large numbers is to reduce those large number cases down to bilateral exchanges. With two parties engaged in transactions, transaction costs are lower, which facilitates mutually advantageous exchange. That works well for institutions of organization, but is difficult to apply to institutions of governance because one set of rules is designed for the entire population. Transaction costs are necessarily high, which means that only an elite few will be able to negotiate in the design of those institutions of authority and governance.

The scope of authority of the political elite tends to expand because those in authority seek more power, and the masses often perceive problems and demand that those in power do something to address those problems. The demands of the masses are supported by the academic concept of market failure, which legitimizes the expansion of the elite’s scope of authority. Despite theories of market failure that are used to justify government action, most government programs do not correspond with the problems identified by economic theory. Interventions in response to the demands for government action often create additional unforeseen problems, which leads to more demands for government action. The result is that the scope of authority of the ruling class tends to continually expand as the political elite identify problems and the masses demand that the elite address those problems.

Prior to the Enlightenment, citizens viewed themselves as subjects of their governments, obligated to obey the mandates of the ruling class. Enlightenment thinkers argued that governments should serve their citizens, rather than citizens being servants of their governments. This had a constraining effect on the abuse of authority, but also led to a romantic notion of democratic governments being accountable to their citizens and acting in their interests, legitimizing the exercise of authority by the ruling class. This chapter discusses the historical evolution of democratic institutions to show how they emerged as a result of negotiations in a political marketplace. One advantage of democratic institutions is that the exercise of authority tends to rest with the positions people hold rather than with those people themselves. This mechanism for peacefully replacing those in authority constrains their ability to abuse their power.

While elites cooperate with each other, transacting in the political marketplace for their mutual benefit, they also compete with each other in other ways. They often have different policy agendas, but more significantly, they compete with each other for power. Those lower on the hierarchy of power work to displace those above them, and a division of power within government leads them to try to increase their scope of power, often by infringing on the power of other members of the elite. A system of checks and balances helps control the abuse of power by those who have it. The masses have little power, and the powerless cannot constrain the powerful even if the powerless far outnumber the powerful. The most effective way to constrain the abuse of power by the ruling class is to maintain institutions that facilitate competition among elites.

Market institutions, including institutions in the political marketplace, are created to facilitate the ability of individuals to exchange for their mutual benefit. This chapter begins with an analysis of markets for goods and services, with the idea that those same principles of market exchange carry over into political markets. A general equilibrium framework is used to depict the outcome of exchange under the assumption that there are no transaction costs to impede mutually advantageous exchanges. That model is institution-free, so the chapter continues to analyze what institutions would be necessary to produce that general equilibrium outcome in an environment in which there are transaction costs. The chapter notes that institutions have three economic functions: lowering transaction costs, enforcing rights and contracts, and redistribution. The chapter analyzes those first two functions, deferring a discussion of redistribution until Chapter 8.

Institutions that lower transaction costs are effective only to the extent that they are enforced. Effective enforcement requires that the enforcers are able to display a capacity to use force sufficient to make people perceive that noncompliance would be futile. Institutions of authority, based on the threat of force to be used against those who do not comply, are controlled by the political elite. Once the ruling class has this authority, they can use their power to extend their scope of authority to other activities, such as producing goods and services and redistributing income and wealth. Because institutions of authority are a necessary foundation for an orderly society, there is no effective way for the masses to escape from being subject to them.

The primary motivation of members of the ruling class is the quest for power. Power, which enables people to accomplish other goals, is also a desired end in itself. Those who have the greatest desire for power will self-select into activities that allow them to exercise power over others. Participants in the political marketplace will be most successful if they are open to negotiating any offer from other participants, which implies that principled politicians will be at a disadvantage to those who are less principled. In their quest for power, the ruling class seeks stability to prevent challengers from displacing them. Creative destruction, in markets for goods and services and in the political marketplace, works against the elite, so there is a tendency for the economic and political elite to work together to prevent that creative destruction. Unchecked, this tendency can displace progress with stagnation.

Exchange within the political marketplace, just like the marketplace for goods and services, takes place within an institutional structure that lowers transaction costs to facilitate political exchange. One difference is that whereas institutional constraints in markets for goods and services typically are enforced by a third party – government – institutional constraints in the political marketplace are enforced by those who are constrained by them. This chapter discusses a variety of political institutions, and explains why those institutions, in general, are designed to enable the political elite to maintain their power against potential challengers. Recognizing the way that political institutions are designed to protect the power of the incumbent elite, the chapter concludes that the most important dimension of political competition is the competition between elites and challengers, not competition among parties.

How George Peabody’s firm became ensnared in the panic, jeopardizing Junius’s new partnership with Peabody and Morgan’s training there. The first test of Morgan’s mettle: Could he meet the challenge of a financial crisis? He showed deep empathy and compassion for his father’s anxiety and discomfort as Junius and George Peabody managed their way through the crisis. Father told him in 1857, “You are commencing upon your business career at an eventful time. Let what you now witness make an impression not to be eradicated. In making haste to be rich how many fall; slow and sure should be the motto of every young man.”