Improvement of rules
An improvement in the rules under which the economy functions can also increase output. The legal system of a country influences the ability of people to cooperate with one another and produce goods. Changes in legal institutions that promote social cooperation and motivate people to produce will also push the production possibilities curve outward. On the other hand, poor institutions can reduce both the level of resources used (shifting the curve inward) and how efficiently they are used (causing the economy to operate inside its production possibilities curve).
Historically, legal innovations have been an important source of economic progress.
During the eighteenth century, a system of patents was established in Europe and North America, giving inventors private-property rights to their ideas. At about the same time, laws were passed allowing businesses to establish themselves legally as corporations, reducing the cost of forming large firms that were often required for the mass production of manufactured goods. Both of these legal changes improved economic organization and accelerated the growth of output by shifting the production possibilities curve outward more rapidly.
Sometimes governments, perhaps because of ignorance or prejudice, adopt legal institutions that reduce production possibilities. Laws that restrict or prohibit trade is one example. For almost a hunderd years following the American Civil War, the laws of several southern states prohibited hiring African-Americans for certain jobs and restricted other economic exchanges between blacks and whites. The legislation not only was harmful to African-Americans, it also retarded progress and reduced the production possibilities of these states.
The collapse of communism in the 1980s also illustrates the importance of economic institutions. After the collapse, Russia was unable to develop legal institutions protecting property rights and enforcing contracts. The absence of these institutions hampered investment and the gains from trade. Investors moved their money to countries with more secure property rights, and resources within the country were used inefficiently because trade was hindered. As a result, even though Russia has a well-educated labor force and abundant natural resources, its economic performance has been poor.