Economic Analysis of Property Rights [3 ed.] 9781009374736, 9781009374712, 9781009374729, 1009374737

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Economic Analysis of Property Rights Third Edition

The standard neoclassical model of economics is incapable of explaining why one form of organization arises over another. It is a model where transaction costs are implicitly assumed to not exist; however, transaction costs are here defined as the costs of strengthening a given distribution of economic property rights, and they always exist. Economic Analysis of Property Rights is a study of how individuals organize resources to maximize the value of their economic rights over these resources. It offers a unified theoretical structure to deal with exchange, rights formation, and organization that traditional economic theory often ignores. It explains how transaction costs can be reduced through reorganization and, in the end, how the distribution of property rights that exists is the one that maximizes wealth net of these transaction costs. This necessary hypothesis explains much of the puzzling organizations and institutions that exist now and have existed in the past. Yoram Barzel (1931–2022) was Professor Emeritus of the University of Washington. He published extensively and helped create the field of economic property rights. He published A Theory of the State (Cambridge, 2002), was president of the Western Economic Association in 2001, and winner of the Elinor Ostrom Lifetime Achievement Award in 2017. Douglas W. Allen is Burnaby Mountain Professor of Economics, Simon Fraser University, British Columbia. He has contributed to the theory of transaction costs and property rights in over ninety publications. His books include The Institutional Revolution (Chicago, 2012) which won the Douglass North 2014 book prize.

POLITICAL ECONOMY OF INSTITUTIONS AND DECISIONS

Series Editors Jeffry Frieden, Harvard University John Patty, Emory University Elizabeth Maggie Penn, Emory University Founding Editors James E. Alt, Harvard University Douglass C. North, Washington University of St. Louis Other books in the series Faisal Ahmed, Conquests and Rents: A Political Economy of Dictatorship and Violence in Muslim Societies Alberto Alesina and Howard Rosenthal, Partisan Politics, Divided Government and the Economy Lee J. Alston, Thrainn Eggertsson and Douglass C. North, eds., Empirical Studies in Institutional Change Lee J. Alston and Joseph P. Ferrie, Southern Paternalism and the Rise of the American Welfare State: Economics, Politics, and Institutions, 1865–1965 James E. Alt and Kenneth Shepsle, eds., Perspectives on Positive Political Economy Josephine T. Andrews, When Majorities Fail: The Russian Parliament, 1990–1993 Jeffrey S. Banks and Eric A. Hanushek, eds., Modern Political Economy: Old Topics, New Directions Yoram Barzel, Economic Analysis of Property Rights, 2nd edition Yoram Barzel, A Theory of the State: Economic Rights, Legal Rights, and the Scope of the State Robert Bates, Beyond the Miracle of the Market: The Political Economy of Agrarian Development in Kenya Jenna Bednar, The Robust Federation: Principles of Design Adam Bonica and Maya Sen, The Judicial Tug of War: How Lawyers, Politicians, and Ideological Incentives Shape the American Judiciary Charles M. Cameron, Veto Bargaining: Presidents and the Politics of Negative Power Erin Baggott Carter and Brett L. Carter, Propaganda in Autocracies: Institutions, Information, and the Politics of Belief Kelly H. Chang, Appointing Central Bankers: The Politics of Monetary Policy in the United States and the European Monetary Union Tom S. Clark The Supreme Court: An Analytical History of Constitutional Decision Making Mark Copelovitch and David A. Singer, Banks on the Brink: Global Capital, Securities Markets, and the Political Roots of Financial Crises (Continued on page following index)

Economic Analysis of Property Rights Third Edition YORAM BARZEL University of Washington

DOUGLAS W. ALLEN Simon Fraser University, British Columbia

Shaftesbury Road, Cambridge C B2 8 E A, United Kingdom One Liberty Plaza, 20th Floor, New York, N Y 10006, USA 477 Williamstown Road, Port Melbourne, V I C 3207, Australia 314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India 103 Penang Road, #05–06/07, Visioncrest Commercial, Singapore 238467 Cambridge University Press is part of Cambridge University Press & Assessment, a department of the University of Cambridge. We share the University’s mission to contribute to society through the pursuit of education, learning and research at the highest international levels of excellence. www.cambridge.org Information on this title: www.cambridge.org/9781009374736 DOI :

10.1017/9781009374712

First and Second editions © Yoram Barzel 1997 Third edition © Yoram Barzel and Douglas W. Allen 2023 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press & Assessment. Third edition published 2023 First edition published 1989 Second edition published 1997 Reprinted 1999, 2000, 2003, 2005 A catalogue record for this publication is available from the British Library Library of Congress Cataloging-in-Publication Data N A M E S : Barzel, Yoram, author. | Allen, Douglas W., author. T I T L E : Economic analysis of property rights / Yoram Barzel, University of Washington, Douglas W. Allen, Simon Fraser University, British Columbia. Description: Third edition. | New York, NY: Cambridge University Press, 2023. | Includes bibliographical references and index. I D E N T I F I E R S : L C C N 2023007396 (print) | L C C N 2023007397 (ebook) | I S B N 9781009374736 (hardback) | I S B N 9781009374712 (ebook) S U B J E C T S : L C S H : Property. | Right of property. C L A S S I F I C AT I O N : L C C H B 701 . B 37 2023 (print) | L C C H B 701 (ebook) | D D C 330.1/7–dc23/eng/20230602 L C record available at https://lccn.loc.gov/2023007396 L C ebook record available at https://lccn.loc.gov/2023007397 ISBN ISBN

978-1-009-37473-6 Hardback 978-1-009-37472-9 Paperback

Cambridge University Press & Assessment has no responsibility for the persistence or accuracy of URLs for external or third-party internet websites referred to in this publication and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.

Contents

List of Figures List of Tables Preface to the Third Edition Preface to the Second Edition Preface to the First Edition

page ix xi xiii xv xvii

P A R T I: C O N C E P T U A L I S S U E S

1

1 The Neoclassical Problem 2 Economic Property Rights

3 14

3 Transaction Costs 4 Information Costs

33 50

5 The Theory of Economic Property Rights

64

P A R T II : C O N T R A C T S , O R G A N I Z A T I O N S , A N D I N S T I T U T I O N S

79

6 Exchange, Contracts, and Contract Choice 7 Divided Ownership and Organization

81 110

8 Institutions

135

P A R T III : E S T A B L I S H I N G P R O P E R T Y R I G H T S

159

9 Capture in the Public Domain 10 Forming Property Rights 11 Benefits of the Public Domain

161 181 205

P A R T IV: N O N - P R I C E A L L O C A T I O N A N D O T H E R I S S U E S

217

12 Nonwage Labor Markets 13 Property Rights in Non-market Allocations

219 232

vii

viii

Contents

14 Additional Property Rights Applications 15 The Property Rights Model

243 254

References Index

261 273

Figures

1.1 2.1 3.1 3.2 3.3 3.4 4.1 6.1 6.2 6.3 6.4 8.1 9.1 9.2 9.3 9.4 9.5 9.6 9.7 10.1 10.2 10.3 11.1 11.2 12.1

Ownership and optimal allocation Different definitions of property rights Wealth and property right perfection I Wealth and property right perfection II Optimal property right strength Crude divorce rate 1922–2008, Canada Sales for a given distribution of tastes The effect of a tax on the level of farm labor The transfer of wealth from sharing Transaction costs of land rental contract Fixing a complementary attribute level The institution of marriage Demands as functions of prices or time Individual and market demands in terms of time Racing equilibrium Heterogeneous land qualities Simple price control Price control, heterogeneous waiting costs Minimizing dissipation Forming private property Private property and imperfection Optimal value of good Homesteader arrival, with/without railroad arrival Homestead arrivals by year Slave Labor Supply

page 7 20 37 38 42 46 52 86 87 90 94 145 163 165 169 170 172 173 179 189 190 194 209 215 224

ix

Tables

3.1 Joint values married and divorced: Efficient marriage 3.2 Joint values married and divorced: Inefficient marriage 4.1 Examples of variability and alterability

page 45 48 54

xi

Preface to the Third Edition

When I wrote the first edition of Economic Analysis of Property Rights in the mid-1980s, I was Douglas Allen’s PhD supervisor. He had been taught as an undergraduate by another former student – Chris Hall – and had arrived in Seattle already well versed in the University of Washington School of Property Rights thought. We met in the spring of 1985 after I returned from a sabbatical in Israel, and we have been friends, colleagues, and co-authors ever since. Doug was heavily involved (and thanked) in the first edition of the book. He read every page and critically commented on my ideas. At the time he was formulating his own ideas on transaction costs, and his 1988 thesis explicitly linked these costs with the concept of property rights for the first time (later published in Allen, 1991a). He has gone on to publish over ninety articles utilizing the economic property rights approach, and he has published two significant books demonstrating how operational it is: The Nature of the Farm (with my former student Dean Lueck) and The Institutional Revolution (which won the Douglass North prize). It was only natural, then, that I would ask Doug to help with a third edition of the book. I asked ten years ago, but it took some time for him to relent. The result is a significant change from the second edition. The book has doubled in size and so the number of chapters. Much of this additional material is up front, where we now spend five chapters developing the fundamental ideas behind an economic analysis of property rights. Every chapter has new material, and there is a new chapter on the relationship between property rights and institutions. One thing that has not changed is the target audience. Like the first two editions, there has been an attempt to “appeal both to those with little training in economics and to specialists.” For students in both economics and related fields, the mostly verbal text should allow easy access. For those well versed in institutional economics, the detailed discussion of fundamental property

xiii

xiv

Preface to the Third Edition

right ideas and the linkage of these ideas to the concepts of organizations and institutions should also provide some utility. We would like to thank Lee Alston, David Friedman, Jonathan Greenacre, Avner Greif, D. Bruce Johnsen, Ennio Piano, and last (but never least) John Wallis for all of their comments. We might not always agree, but everyone helped us in articulating our own ideas better. Special thanks are due to Aurora Stephany (MA, Economics, University of Washington) for her extensive discussions with Barzel on the theory of information and the marriage contract.

Preface to the Second Edition

Since the publication of the first edition of this book, I have continued to conduct research regarding economic organization and political economy. This work is reflected primarily in Chapters 5 and 6 of the current edition. I have also separated the discussion of divided ownership from that of the firm. The former now occupies Chapter 4, whereas in Chapter 5, I offer new thoughts on the latter. In Chapter 6, I briefly speculate on the emergence of property rights and the state. Teaching property rights courses over the last few years has led me to discover in the first edition some errors, many ambiguities, and several instances that call for elaboration. I have attempted to correct the mistakes, clarify the exposition, and elaborate when necessary. I have also added a number of illustrations, some of which derive from new research on property rights. I wish to thank Dean Lueck, who read the entire manuscript, for his helpful comments; my daughter Tamar, for enlivening the presentation and protecting the English language; and the Earhart Foundation for its generous financial support.

xv

Preface to the First Edition

The intellectual content of “property rights,” a term that has enchanted and occasionally mesmerized economists, seems to lie within the jurisdiction of the legal profession. Consistent with their imperialist tendencies, however, economists have also attempted to appropriate it. Both disciplines can justify their claims, since the term is given different meanings on different occasions. Perhaps economists should initially have coined a term distinct from the one used for legal purposes, but by now the cost of doing so is too high. I attempt, however, to make clear the meaning I give to “property rights” and to demonstrate why property rights so defined are an appropriate subject for economic analysis. The material of the book is at the heart of a course I have taught in recent years. Undergraduate students take my approach in stride. Graduate students often vigorously resist my dissatisfaction with the zero transaction costs model; converting them is, however, rewarding. This book is influenced by the diverse classroom reactions. It is an attempt to appeal both to those with little training in economics and to specialists. I am grateful to my former students Douglas Allen and Dean Lueck and to my colleague Paul Heyne, who read early drafts of the book and forced me to reformulate many of my ideas and to clarify their presentation. Douglass North, who supported the project from its infancy, also read the entire manuscript and made numerous valuable suggestions. Victor Goldberg and Levis Kochin provided useful comments as well. I also thank Elizabeth Case and my daughter Tamar for excellent editing; they demonstrated that clear writing enhances clear thinking. Finally, I wish to thank the Earhart Foundation for financial support.

xvii

PART I

CONCEPTUAL ISSUES

The concept of economic property rights is not “just another tool” in the economic kit, and such rights are not a monolithic, exogenous parameter that simply shifts one type of function or another. Nor are economic property rights simple in the sense that they are independent of production and can be swapped out or altered in the way one might change the oil in a car. Economic property rights are complex, nuanced, and tied to acts of exchange and production. As such, they are a foundational concept in the understanding of resource allocation, organization, and institutions. This foundational nature has been abstracted from in most areas of economics, and even when such things as “property rights,” “institutions,” or “organizations” are referred to, the meaning is often simple and neoclassical. This often means that the linkage between property rights, transaction costs, and institutions is missing because it is irrelevant within this context of zero information costs. Economic property rights are theoretically linked to transaction and information costs and matter for organization and institutions when these costs are positive. Without proper articulation and theoretical linkages between these concepts, there can be no understanding of the logic of an economic property rights analysis; of how economic property rights are created, enhanced, and traded; nor how economic property rights relate to the various particular transaction cost behaviors that economists have studied for so long. The first part of the book lays out these issues. Chapter 1 starts with the Coase Theorem, a misunderstood and misapplied idea if ever there was one. We argue that this idea is relevant only because it demonstrates that traditional neoclassical theory is incapable of shedding light on the variation in economic property rights because it implicitly assumes zero transaction costs. Positive transaction costs, therefore, are a necessary component of a theory of property rights.

1

2

Part I Conceptual Issues

Chapter 2 goes into considerable detail on what property rights are. It first distinguishes between economic, legal, and natural rights, but then articulates a general framework for describing economic property rights called the distribution of property rights. This framework distinguishes three different dimensions of economic property rights: their division across different commodity attributes, their bundling across different people, and the strength of a given right over a given attribute. Chapter 3 builds on the concept of economic property rights and explains the functional relationship between joint wealth and the distribution of property rights. Wealth increases in the strength of property rights, but this can be accomplished directly through greater efforts to enforce rights or indirectly through changes in the division across attributes or bundles of rights. This relationship culminates in a definition of transaction costs that is functionally related to the concept of economic property rights: Transaction costs are the costs of establishing and maintaining the distribution of economic property rights. This definition is necessary for a proper understanding of the Coase Theorem: Why it matters and when it fails. Chapter 4 provides a discussion of information costs and shows how a particular type of information cost determines the level and type of transaction cost that exists – namely information over the nature of commodity attributes. Once the issues of property rights, transaction costs, and information costs are specified, Chapter 5 finally articulates the general theory of economic property rights that is applied throughout the rest of the book: All distributions of property rights maximize joint wealth net of transaction costs. Property rights apply to all “things,” including people. For the most part, we will refer to these things as “goods,” “commodities,” or “assets.” What term is used will depend on the context, but they are mostly interchangeable. We also have a very broad understanding of “goods.” They can be physical and measurable or nonphysical (like an idea) and difficult to observe.

1 The Neoclassical Problem

INTRODUCTION

In this book, we provide the theoretical and operational foundations of economic property rights and provide multiple applications of the model. We argue that the organization of economic activity and resource allocation are best understood through the concept of ownership. In life, most things we consume are first produced in some way, shipped by often complex methods, and then sold to the ultimate consumers through a variety of methods. Every aspect of this production and exchange is organized around a series of owners. The pattern of ownership over the inputs and produced goods varies as dramatically as the types of goods that are produced and consumed. This pattern of ownership is not random, nor is it irrelevant. Indeed, it is just the opposite: The role of ownership is essential and necessary for any and all economic activity. The neoclassical model at the core of most economic tool kits is extremely useful for analyzing how much of something gets produced, traded, and consumed – and at what price – and it dominates the way economists think about everything. However, it has nothing to say about ownership. An economist begins their training with a study of markets in a traditional supply and demand framework where everything there is to know, including prices, is implicitly determined at no cost. In this model, prices adjust instantaneously to ensure that markets clear. Moreover, every commodity in the model is perfectly and completely owned, and therefore ownership never varies in its strength and never matters. As a consequence, economists naturally default to thinking of prices as the sole means by which resources are allocated. It is easy to see, however, that most commodities are not allocated by price alone, even in industries we think of as price-taking competitive. Waiting in line for restaurants, movies, or at the grocery store during the afternoon rush is common, and so allocation is partly determined by time. Waiting also takes 3

4

Part I Conceptual Issues

place in the form of unemployment of both labor and capital, and wages and rental rates do not quickly adjust to eliminate the excess supply. Prices are not used to allocate places for cars on the highway, patients in an emergency room, grades in a classroom, ambulances for acute illness, police to a crime scene, verdicts from a judge, or fishing on the high seas. Even the simple purchase of oranges involves more than price alone; buyers exert some effort to examine the fruit in order to take the good ones and leave the poorer ones for others. And, within firms and families, direction – rather than prices – is the norm. Once we consider the actual forms of allocation, we realize that nothing is allocated purely by price. When nothing is allocated purely and freely by price, then nothing is ever perfectly and completely owned. Every line of people announces that some valuable good of the seller is in the public domain and is now being captured by those willing to wait. Every time an orange is squeezed and taken, the consumer reveals that that particular fruit is of high quality and underpriced; therefore, the seller is not the full owner of that orange because he is unable to capture its full value. Economists have been aware of this shortcoming of the neoclassical model as a description of reality for a long time, but many attempts to fix it have not been successful. Early attempts to deal with matters of alternatives to the price mechanism were considered an advanced subtopic in “price theory.” This often amounted to dealing with production functions and altering costfunction models of the firm. It was not just ad hoc tinkering, but it treated ownership and its costs as a “black box,” described by a simple technology or cost parameter. Within this framework, “better ownership” or “lower transaction costs” simply amounted to a shift in a demand or supply curve or a reduction in some type of friction cost. In these models, a reduction in, say trading costs, simply increased the amount of trade and reduced price spreads. There is nothing wrong with these “law of demand” or “tax analysis” applications; however, they hardly deal with the role of ownership. This type of framework does not look inside the box. A more sophisticated, but also limited, means of addressing issues of ownership has been to consider only matters of legal ownership. Indeed, for most working in the area of “property rights” – especially in the growing empirical literature – ownership is often synonymous with legal rights.1 In such 1

This old and dominant tradition in economics possibly goes all the way back to Adam Smith who claimed in the Wealth of Nations that the sovereign’s duty was to protect citizens from injustice and oppression by others, that is, enforce legal rights. Coase (1960) examined social costs in terms of legal liability rules that were synonymous with an allocation of ownership rights. Calabresi and Melamed (1972) understood ownership rights as either legal property rules or legal liability rules. Hernando De Soto (2000) popularized the idea that individual rights meant rights that are formal, legal, and backed by the state. Hodgson (2015) argued that fully developed legal systems that codify individual property rights are the source of growth and that creating legal property over debt was the source of growth after 1800. Even the most recent research treats property rights as legal rights. Behrer, Glaeser, and Shleifer (2021) consider

The Neoclassical Problem

5

cases, “more and better ownership” often means strong state enforcement of legal rights; well-defined constitutions, titling systems, and other explicit delineations of legal authority; limits on eminent domain and restrictions on the powers of the state; and well-functioning courts, and legal systems of civil dispute resolution. These institutional features of property are extremely important; however, they capture only part of what ownership means, and they are ultimately institutional supports for the type of ownership that actually matters – economic property rights. Over time, attempts to deal with the question of ownership and “property rights” led to the emergence of various subfields such as “law and economics,” “contract theory,” “organization theory,” and “new institutional economics.” On the one hand, work in these fields, as well as in other social sciences, recognized the presence of inconsistencies and problems with neoclassical modeling patchwork related to ownership. Considerable progress has been made in explicitly exploring the effects of positive information costs and the resulting positive transaction costs on behavior and on ownership and organization.2 On the other hand, as a result of these different historical paths, a systematic body of knowledge to handle this problem is still lacking. Ideas, definitions, and models are often disparate or duplications, and there remains confusion over the relationship between fundamental concepts. It is common to see terms like “property,” “governance,” “institutions,” or “organizations” being used without common meaning, theoretical foundations, or conceptual connection. This book addresses these issues and provides theoretical and operational foundations to the theory of economic property rights. In doing so, we explain why the neoclassical model necessarily fails as a framework for understanding and explaining non-price allocations. We argue that three fundamental concepts – costly information, imperfect property rights, and positive transaction costs – are necessary and sufficient for a theory of organization and resource allocation. We show how these ideas clarify what lies behind other economic concepts like agency, rent seeking, shirking, moral hazard, adverse selection, etc. and reveal the common features they have. We also provide a property rights understanding of institutions and link this to the concept of economic property rights. This provides a missing link in the understanding of why institutions matter so much for exchange, production, and growth. In the end, we generate an operational model of the maximizing pattern of ownership, and this is able to explain the behavior that is generally inconsistent with the neoclassical model. We begin in this chapter, however, with a discussion of the Coase Theorem. The Coase Theorem is well known, and a long trail of academic work exists

2

enhancing justice as equivalent to “securing property rights.” For a survey of this particular literature, see Mijiyawa (2013). This literature is enormous and imposing, and we attempt no survey of it. Some surveys include Eggertsson (1990), Williamson and Masten (1999), Ostrom (2000), Mehrdad (2011), Locke (2013), and Alston et al. (2018).

Part I Conceptual Issues

6

that documents its history; some of it is critical of its various elements, and some of it defends its logic and conclusions. We, however, only focus on its logical implication for understanding property rights.3 We are in agreement with Coase, who strongly believed that the Coase Theorem does not describe reality nor is it a useful policy tool.4 Rather, the Coase Theorem makes it clear that the usual assumptions of the neoclassical model can never address the question of the organization of exchange and production, and it points to the source of this failure.

THE COASE THEOREM

Coase was an intuitive economist. In his 1959 article on the US Federal Communication Commission he pointed out, though practically almost in passing, that assets will be employed in their most valued use regardless of who owns them; that is, the allocation of assets is independent of ownership. Of all things, he illustrated the case via the use of a cave: Whether the cave is used for storing bank records, as a natural gas reservoir, or for growing mushrooms depends, not on the law of property, but on whether the bank, the natural gas corporation, or the mushroom concern will pay the most in order to be able to use the cave. (Coase 1959, p. 25)

In this passage, he subtly hints at a distinction between legal rights and economic rights – a distinction we will elaborate on in Chapter 2. It is worthwhile pointing out that when Coase brings up “law of property,” he had in mind a matter of legal ownership.5 Coase, like many others, thought of property as a “bundle of rights” assigned by law (either statutory or common law), and so Coase was stating that the pattern of legal ownership over the use of the cave is irrelevant to how it would be used. When the cave is owned, it gets used in a way that maximizes its value, and that method does not depend on who owns it when there is “... clear delimitation of rights” (1959, p. 25). This statement struck many economists at the time as wrong or at best incomplete. Of course ownership matters! Coase famously presented his claim to a group of University of Chicago economists at the home of Aaron

3 4

5

Medema, the world’s expert on the history of the Coase Theorem, has extensively documented it in Medema (2020, 2021). In the introduction to his selected works and in reference to why he wrote what was to become known as the Coase Theorem, Coase states: My aim in so doing was not to describe what life would be like in such a world but to provide a simple setting in which to develop the analysis and, what was even more important, to make clear the fundamental role which transaction costs do, and should, play in the fashioning of the institutions which make up the economic system. (1988, p. 13) For Coase, legal ownership was all or nothing. He did not entertain the notion that something could be imperfectly owned, a critical distinction central to this book.

The Neoclassical Problem

7

$ MC

90

MV 0

60

FIGURE

100 QCoconuts

1.1 Ownership and optimal allocation

Director.6 Over the course of an evening, Coase defended himself against the likes of George Stigler and Milton Friedman, and eventually won them over. This was followed by the publication of the Problem of Social Cost, which despite its flaws remains a watershed – though mostly misunderstood – paper in the development of the economics of property rights and transaction costs. The first four sections of Coase’s 1960 paper on social costs generated the result known as the “Coase Theorem.” In this chapter, we explore this theorem and consider what it means for a theory of property rights. For the moment, it is sufficient for our purpose to recognize Coase’s statements of “clear delimitation of rights” and “the pricing system works smoothly (strictly this means that the operation of a pricing system is without cost)” (Coase 1960, p. 2) to mean a world described by the neoclassical model. Given that Coase’s claim regarding the cave’s use was made in the context of the neoclassical model (where all things are freely known), it is ironic that so many neoclassical economists who made the same assumption objected to it. Consider Figure 1.1, which is a stylized marginal value and marginal cost graph of coconuts for a fellow named Robinson Crusoe who lives alone, not in a cave, but on a desert island. Crusoe’s marginal value of coconuts slopes downward, and as he collects them he has less time remaining for other activities, which raises the marginal value of other activities, making his marginal cost of collecting coconuts upward sloping. In this circumstance, Crusoe “owns” everything: his labor, the coconuts he collects, the other goods he consumes, his thoughts, and on and on. As the only person and sole owner on the island, Crusoe receives all of the benefits of his actions, and he bears all of the costs. Given his preferences, the optimal thing for Crusoe to do is to collect sixty coconuts where his marginal value equals his marginal cost. Now suppose a second person named Friday joins Crusoe on the island, and suppose that Friday doesn’t eat coconuts, but he (and not Crusoe) owns and collects them (at the same marginal cost). Again, it comes as no surprise that since Crusoe wants coconuts, he will engage in trade with Friday – after all, the price system on the island is assumed to work without cost. This trade takes place until the marginal conditions are equal, and once again the optimal 6

This tale is told by Coase in Kitch (1983). See also McCloskey (1998) and Medema (2021).

8

Part I Conceptual Issues

number of coconuts (60) are collected and traded.7 As long as the willingness of Crusoe to pay is greater than Friday’s marginal costs, it is in the interests of both to interact and trade with each other. Whether Crusoe “trades with himself” or trades with Friday is irrelevant. So far, so good. However, following the Pigouvian tradition, the economics profession went astray when the situation differed only slightly. Suppose we go back to the original case where Crusoe is collecting and eating his own coconuts, but now the cost of collection (for some reason) is borne by Friday; that is, Crusoe is in a position to exert an “externality” on Friday. Traditionally, it was claimed that Crusoe would now collect and consume 100 coconuts because seemingly his marginal costs of collection are zero to him. In this case, we could think of Crusoe as not being liable for the costs he inflicts on Friday. Alternatively, we can think of Crusoe owning the right to collect as many coconuts as he wants without regard for others. Either way, it looks like the 100 coconuts being collected is different from the first two cases presented, and 100 is too many in terms of social welfare. Coase’s economic intuition allowed him to see through this problem and realize that just because Crusoe incurred no expenditure on the collection of coconuts, it did not mean that Crusoe ultimately did not bear the costs of collection. Just because the costs are borne by somebody else doesn’t mean the costs do not exist. At 100 coconuts produced, the marginal cost of $90 to Friday exceeds the marginal value of zero to Crusoe, and so (just as in the case where Friday owned the trees) there are gains from trade to be realized. Friday can now pay Crusoe to reduce his production, and the gains from trade are maximized when the same sixty coconuts are collected. Friday’s offer to pay for reduced collection is an opportunity cost to Crusoe. In this way, Friday “internalizes” the externality of Crusoe to achieve the optimal allocation. Coase went on to point out that in general, had the tables been turned in terms of who held the ownership and liability, the outcome still would have been the same. For example, if Friday was able to dictate that Crusoe could not collect coconuts (or if Crusoe was liable for the harm caused), the interaction doesn’t stop there. As Coase put it, the problem is reciprocal: Crusoe’s willingness to pay for coconuts is a cost to Friday in placing the restriction on Crusoe. Since there remains gains from trade, the two exploit the situation, and again, the outcome is the same. In each of the four cases just considered, the distribution of ownership varied but the total number of coconuts collected remained the same. The final allocation of goods did not depend on the number of people, how the costs and benefits were distributed, or if one person could initially select a specific quantity of collection (like 100 or 0). All that mattered were the economic 7

A common objection is that Crusoe and Friday might haggle over the gains from trade, and therefore the optimal allocation might not arise. However, since prices are costless and apply to everything, the division of the gains are also priced and there is no bilateral monopoly problem (Allen 1997).

The Neoclassical Problem

9

primitives: the value placed on coconuts and other goods and the costs of collecting them – as long as the “market worked freely.” This independence result is called the “Coase Theorem,” and it hinges on Coase’s condition of “the operation of a pricing system is without cost.” For the moment, we will assert this condition is equivalent to “zero transaction costs” and state the Coase Theorem as, Coase Theorem: When transaction costs are zero, the allocation of resources is independent of the distribution of property rights.

In the context of the coconuts, this could be stated, “when the price system operates without cost the number of coconuts collected doesn’t depend on who owns them.” But it must be recognized that the general definition hides a great deal of conceptual complexity. It clearly rests on a precise definitional understanding of “transaction costs” and “property rights,” and these will be dealt with in Chapters 2 and 3. For the moment, however, we put aside these issues and discuss the significance of Coase’s idea for a theory of ownership. THE COASE THEOREM : AN IDEA , NOT A REALITY

The name “Coase Theorem” is attributed to George Stigler. In highlighting this idea, Stigler (and many others) implied that it was a useful idea to understand reality, and that it was, in fact, an operational idea. It is nothing of this sort, however, because we do not live in a world of zero transaction costs. Coase was appalled that his name was associated with the supposed applicability of this idea to the real world. To do so takes the idea out of the context in which it was written. In 1988, Coase wrote: The extensive discussion ... has concentrated almost entirely on the “Coase Theorem,” a proposition about the world of zero transaction costs. ... the world of modern economic analysis. (p. 15) ... The world of zero transaction costs has often been described as a Coasean world. Nothing could be further from the truth. It is the world of modern economic theory, one which I was hoping to persuade economists to leave. (p. 174)

Coase was not articulating this particular property of the neoclassical model because he thought it was true of the world or a policy goal to aspire to. Rather, Coase was pointing out a failure of the neoclassical model. To him the idea that the distribution of ownership should be of no consequence in reality was absurd. Coase’s point in his opening sections Social Cost was that because one type of ownership is as good as another in the neoclassical model, that model is incapable of explaining the distribution, or pattern, of ownership. The Coase Theorem depends on the assumption of zero transaction costs. In 1960, Coase had stated that his argument rested on the assumption that the price system “worked without cost.” Years later, he would acknowledge that his idea concerned a situation where “transaction costs, explicitly or implicitly, are assumed to be zero” (1988, p. 15). Therefore, transaction costs are a necessary component for any theory of ownership. If they are zero, ownership

10

Part I Conceptual Issues

doesn’t matter; if they are positive, ownership does matter. Hence, the real point of the Coase Theorem is a methodological one: It tells us the critical element of a theory of ownership: the necessity of positive transaction costs.8 There have been many attempts to “test” the Coase Theorem. These take the form of examining whether or not any changes in some particular outcome arose based on changes in some type of ownership structure. These tests have examined, among other things, whether different farm contracts lead to the same level of crop production; whether payment bonuses going to employers doing the hiring leads to different levels of employment compared to cases where the bonus goes to the worker accepting the job; or whether free agency makes any difference in which teams professional athletes play for. Other types of tests have looked at whether neighbors bargain with each other when cattle go astray and destroy crops, or whether beekeepers and orchard owners are even able to contract with one another given the double externality of pollination and honey production. Sometimes results are found that are supposedly consistent with the Coase Theorem, but most of the time it is rejected (Bertrand 2019). Such testing misses the point – the Coase Theorem is not testable. To test the idea, one would have to find a situation where transaction costs are zero. This never happens in the real world where transaction costs are always positive. Like the mathematical concept of infinity, the Coase Theorem is an idea, it is not a reality. But also like infinity, it is a useful idea. THE NEOCLASSICAL PROBLEM

The Coase Theorem’s usefulness comes from directing our attention to the problem caused by positive transaction costs. According to the Coase Theorem, when transaction costs are zero, resource allocation is independent of the allocation of property rights. The corollary of the Coase Theorem is that when transaction costs are positive, then the allocation of resources and subsequent levels of production do depend on the allocation of property rights. We will argue that the real world is characterized by the presence of positive transaction costs, and therefore the allocation of property rights in the world we live in is significant and has real consequences. Despite not having defined transaction costs yet, let us consider some of the features of the neoclassical world and the role of prices. In the neoclassical model, prices are determined without cost and suffice for all allocation problems. These prices are determined by a fictional volunteer: the “Walrasian auctioneer,” who instantly and perfectly sets prices to clear markets. However, in the real world, no such auctioneer exists and exchange normally requires additional costs to determine prices. Costly determination of prices means that often non-price allocation methods are used with (or instead of) prices, and 8

Many have thought this point only holds if changes in income are ignored. This is flawed and results from an inadequate understanding of transaction costs. See Allen (1997).

The Neoclassical Problem

11

these methods often require corresponding organizations to function. But these organizations are also costly! When equilibrium is disturbed, a new equilibrium is instantaneously attained under the neoclassical model because, given the volunteer auctioneer, the cost of adjustment – another feature of the neoclassical world – is zero. In addition, neoclassical commodities are made up of strictly identical specimens, people are fully informed regarding the exchanged commodities, the terms of trade are always perfectly clear, and trade is instantaneous. As a result, neither a buyer nor a seller ever has to make any effort or incur any cost of operating in the market other than for the buyer to dispense the appropriate money payment and for the seller to cede the appropriate units of the good.9 Prices alone always suffice to allocate resources to their highest-value uses, even as conditions change. However, in the real world, when equilibrium is disturbed, a price adjustment is not expected to be instantaneous. As long as prices are not fully adjusted to new conditions, the quantities demanded are not, in general, equal to those supplied. Any excess demand or supply means that some wealth can be captured by the transacting parties. Since the level to which this happens depends on the distribution of ownership, again, resource allocation is affected. Where transaction costs are positive, a whole array of activities are required to effect exchange; money with which to pay the pecuniary price is, of course, helpful but definitely not sufficient. Because of the complexity of exchange, maximizing parties have many opportunities to act so as to gain from exploiting the discrepancy between the price actually charged and the one that would have achieved equilibrium, and their actions yield the new equilibrium. To illustrate, consider some of the activities required to generate purchases in stores. Buyers must decide, among other things, where to shop, whether to shop during the busiest hours (when, at the going price, the quantity demanded exceeds that supplied), or at off-peak times (when the reverse is true). They must then obtain all sorts of information: identify the location of the desired merchandise; determine by themselves or with the help of the sellers if the items they seek are available; determine if they are of the appropriate quality; select the specimens they think are best; ascertain the price, over which they may haggle; and make payment, not necessarily in cash. In addition, they may have to take care of warranties and, on occasion, exchange the merchandise. Completing purchases, then, involves an elaborate set of operations. More important, these operations are costly, and they can be altered. For instance, at any particular time, a buyer may exercise return privileges more vigorously and a seller may be out of an item that is usually in plentiful supply, or may unexpectedly help carry the merchandise to a customer’s car. 9

This also implies that there can be no theft in the neoclassical model, either in terms of a small scale robbery or indeed a large scale war.

12

Part I Conceptual Issues

When the market-clearing price changes but the nominal price does not, buyers and sellers may still adjust in many ways. For example, a seller who is in control of the quality of the merchandise or of the number of cashiers per customer will adjust along such margins, especially the latter. Regarding the second margin, supermarkets often reduce the speed of service at rush hours. In general, sellers who choose not to adjust prices or who are prevented from adjusting them may still adjust along these and other margins. Given wealth maximization, the margins along which they will adjust and the corresponding effects on resource allocation are predictable. Despite these adjustments, it is possible to determine how equilibrium is attained. The parties will continue to adjust as long as they can realize net gains from the adjustments. Equilibrium is reached when no more such adjustments are available. The point is, we can easily see that the real world is not characterized by a price system that works for free, either in terms of setting prices or adjusting prices to changing conditions. Costly determination of prices means that alternative methods of allocation might be used, and each alternative may lead to different levels of production and wealth. Once, the Pandora’s box of positive transaction costs is opened, the Coase Theorem ceases to apply. CONCLUSION

At the end of the day, Coase’s analysis of a zero transaction cost world is intended as a reductio ad absurdum. That is, the implications of zero transaction costs are absurd. In such a world, any conflict can be handled equally well by any distribution of rights. Therefore, no distribution of rights has any purpose. Which means also that no norms, customs, laws, firms, organizations, or institutions have any purpose either. Without a purpose, such things should not even exist, let alone exist in any sort of systematic fashion. Since these things clearly matter, transaction costs must be positive and they must provide the essential ingredient in any explanation of the allocation of resources and the formation of private orderings, organizations, and institutions. This fundamental conclusion is the essence of Coase’s work, and therefore, the understanding of “transaction costs” and their relationship to “property rights” is the key to understanding the Coase Theorem and any theory of organization.10 All of this is missed when the focus is on inappropriately applying the Coase Theorem to the real world. Although the neoclassical model is often extended beyond the analysis of formal markets, it remains true that it can only address questions it was designed for; namely the study of quantities and prices. In the same way

10

We do not want to minimize the other elements of the Social Cost paper. Coase’s treatment of externalities and the incoherence of Pigouvian taxation are important; however, they simply are not germane to our analysis of property rights.

The Neoclassical Problem

13

that the neoclassical model fails to explain how market exchange and production take place, it also fails to explain the organization of non-market sector behavior. Moreover, the analysis of positive transaction costs and of property rights is not restricted to the market sector or market economies; on the contrary, it applies everywhere. Indeed, although a property rights analysis is often applied to the capitalist market system only, it is most useful (and the neoclassical model is least useful) in systems in which market prices are least used. As a result, examples in this book will often relate to governments. Governments clearly play a major role with regard to property rights, and they hold rights to various assets and directly participate in economic activities. We will examine other areas of non-market activity as well.

2 Economic Property Rights

INTRODUCTION

In Chapter 1, we argued that “property rights” matter for resource allocation when “transaction costs” are positive, and that therefore, to understand resource allocation, one must understand property rights and transaction costs. This was the critical point Coase was making in the first half of his Social Cost paper. But what are property rights and transaction costs? This chapter addresses the first of these terms in considerable detail. Ultimately, we will argue that economic property rights is the critical concept in understanding the Coase Theorem and therefore the relevant unit of analysis in understanding any resource allocation. Economic property rights are always “spread out” in across several dimensions, and we will call this the “distribution of economic property rights.” It will be shown that this distribution determines the level of transaction costs, and we will argue in Chapter 5 that the distribution of economic property rights chosen is one that maximizes wealth net of these transaction costs. Given the importance of property rights, it is interesting that neither Coase nor most who followed devoted much time to their definition, nor to any linkage with the concept of transaction costs. Indeed, even today property rights are mostly assumed to be a black box of legal rights and independent of transaction costs. In this chapter, we go into considerable detail in terms of the different forms of property rights: economic, legal, and natural. We then concentrate on economic rights as the ultimate unit of analysis for economic behavior. These rights are characterized by three important dimensions: division, completeness, and perfection. Again, confusion over these dimensions abounds and leads to no end of incoherence in the analysis of ownership. However, once the distribution of property rights is defined, it sets the stage in Chapter 3 for a discussion of transaction costs and lays the foundation for the rest of the book. 14

Economic Property Rights

15

PROPERTY RIGHTS

There are three broad understandings of the term “property rights”: economic property rights (sometimes called “de facto” rights), legal property rights (sometimes called “de jure” rights), and natural property rights (sometimes called “moral” or “human” rights). The first is central in the study of organization and behavior because it is the relevant unit of analysis in a theory of choice and because it is functionally dependent on the other two. Often, when “property rights” are discussed, different meanings of the term are being implicitly used, and each person ends up talking past the other. For example, landlords and tenants often fight over the “rights” of whether or not pets can be kept in an apartment. Landlords claim they have a right (meaning legal) to determine the use of their property, while tenants claim they have a right (meaning natural) to have a pet. Both use “rights” language, but a lack of common understanding hinders negotiation.1 Thus, we want to be particular and explicit with the definitions of terms being used in specific situations. Our definition of economic property rights is Economic Property Rights: The individual’s ability (in expected terms) to exercise a choice with respect to a commodity or some other thing.2

The commodity or general “thing” could be anything an individual might conceivably make a choice over. It might be a simple consumer good, a physical asset or capital (including the individual and other people), the stream of income or utility from an asset, or a nonphysical thing like an idea, expression, or digital signature. Choices are often a matter of feasibility, which effects the way we interpret the “thing.” For example, two roommates might share an apartment, and we might think of the “thing” as the entire apartment. However, when both roommates have access to the entire apartment, one’s choices are limited by the choices of the other. Hence, one roommate can only have an economic property right over what is available within the apartment. On the other hand, a landowner and a farmer might share a crop coming off a field. In this case, once the crop is shared, the “thing” is the fraction of crop in possession of each because there is no interference by the other in how one’s share of the crop is used. Specifically, identifying what the “thing” is (whether the entire apartment or a share of the crop) affects how one thinks about the ability to make choices. The “choice” made might include various uses (consumption, destruction, improvements, possession, enjoyment, production), exchange (selling, buying, mortgaging, leasing), transfer (bequeathing, donating, purchasing), and 1

2

Friedman (1994) notes some of the conflicts of trying to understand property rights by using only moral or legal notions. He correctly points out that behavior is often inconsistent with either conception. This definition follows that by Alchian (1965, 1987, 2007), Cheung (1970), Alchian and Allen (1977, p. 114 and 198), and Allen (1991). It is similar to Locke’s (1698) notion of “liberty,” the power to dispose of one’s possessions.

16

Part I Conceptual Issues

importantly, the exclusion of others. These different choices are actually different specific types of economic property rights. At an abstract level, these choices can be bundled together in any combination. Hence, one might have the economic property right over the consumption of the flow of services to an asset but not have the ability (right) to transfer that asset – as when an employee is assigned an office at work. It is very common in economics to ignore the different types of economic property rights that might be attached to a particular commodity and rather treat property rights as a monolithic singular right that somehow enhances decisions. Rather, commodities and assets have embodied in them a set of rights, not just one generic property right. Finally, property rights are a matter of expectation, and this expectation probability expresses the strength of the property right. When a person’s choice is certain the property right is as strong as it can be. However, there are two basic reasons for why this probability is almost always less than one: either someone else can interfere in your choice or nature interferes.3 People interfere with your choices all the time. You might want to drive at 80 mph in a school zone, but the police and others might prohibit you from doing so. You might want to just go for a drive with your car but find that someone has stolen it. Nature also interferes. You may have a garden, and at night the deer and rabbits rid you of the vegetables. In each case, your economic property right is not certain. Others and nature each interfere without permission to hinder (or perhaps enhance) the decisions wished to be made. It follows that, among other things, the more prone to theft a commodity is, the weaker is the economic right over it. It is often difficult to identify where an idea begins, but the explicit concept of “economic rights” seems to have started with Armen Alchian, an eclectic, mostly self-taught economist’s economist who spent his entire career at UCLA and fathered the role and study of economic property rights. Alchian’s early work on tenure (1958) and the pursuit of individual utility within the context of regulated firms (Alchian and Kessel, 1962) hinged on the various economic rights within the context of the institutions in question. For example, managers and administrators of nonprofit firms and universities are not full residual claimants of the organizations in which they work, and therefore they face a lower relative cost of private consumption on the job than their counterparts in the private sector; thus, according to Alchian and Kessel, the carpet in the administrators’ office is likely to be more plush than it would be in a for-profit firm. Because these firms are not constrained in their need to generate profit, they are able to survive with higher costs. Alchian’s insight was that the economic property rights over the firm’s assets determined the level and type of output of the firm because they determined the incentives for each individual within the firm. 3

Alchian and Allen (p. 3, 1972) classically put it this way: “Two villains – nature and other people – prevent us from having all we want.”

Economic Property Rights

17

This theme is manifest throughout Alchian’s work and culminated in his famous article with Demsetz (Alchian and Demsetz, 1972), which argued that firms could be thought of in terms of their different distributions of rights.4 Emphatically, Alchian (1965, 1979, 1987, 2007) clearly made a distinction between economic and legal rights. For Alchian, economic property rights are the ability to enjoy a piece of property; they are “the rights of individuals to the use of resources” (1965, p. 817). This enjoyment is a matter of what actually happens, not just what is legally allowed. Steven Cheung, a student of Alchian’s, pushed the idea of economic rights further in his work on share tenancy, open access resources, and rent control (1969, 1970, 1974). Most notably, he also emphasized that the economic property rights we observe are not solely dependent on the existence of a state, but they also depend on private actions, custom, reciprocity, and voluntary restraints. This notion of the importance of informal norms along with formal laws in determining economic property rights is now commonplace in the modern property rights literature (e.g., Ellickson (1991), Landa (1994), Yonai (2007), Gorlizki (2016)). A critical application of economic property rights is in the rights to the residual of some activity.5 Partly because of random elements, in every act of production and exchange, there is a residual (either positive or negative). By definition, economic rights to residuals belong to those individuals who can control them, whether or not they legally own them, have stolen them, or have captured them from the public domain. Controlling residuals often comes from controlling assets (including people). Not surprisingly, there is an economic benefit to connecting the ownership of an asset to the ownership of residuals. For example, the residual claimant of a building is the one who gains from an increase in the value of the building and loses from a reduction in that value. The residual claimant is motivated to take any action that will, net of its cost, increase the value of the property. For this reason, the economic owner of an asset is always strongly tied to ownership over the residual. The residual claimancy from an asset or an operation is often shared by several individuals, which means there are often multiple economic owners to the asset. An important proposition, to be elaborated on later, is that in order to maximize the value of rights, a person’s share in the residual should increase as his contribution to the mean output increases, and it should fall as his contribution decreases. As we will argue throughout, economic property rights are the individuals’ ends; that is, they are what people ultimately seek and what determine behavior. In contrast to the concept of economic property rights is the more prevalent 4

5

Alchian clearly had a significant impact on the thinking of Harold Demsetz, who also wrote path-breaking articles involving economic property rights. We examine one of Demsetz’s seminal ideas in Chapter 10. We use the notion of residual in the broadest terms. Every action produces benefits and costs, and the residual is simply the difference between the two.

18

Part I Conceptual Issues

and older notion of legal property rights, which is essentially the rights a state assigns to a person. Legal rights are one means – an important one – to achieve the ends of economic property rights. We define legal property rights as Legal Property Rights: The individual’s authority under the law to exercise a choice with respect to some thing.6

The economic rights people have over assets are not constant and are a function of their own direct efforts at maintaining those rights, of other people’s attempts to appropriate them, of formal and informal non-governmental actions, and of governmental protection effected primarily through regulations, the police, and the courts. Legal rights, as a rule therefore, enhance economic rights, but they are neither necessary nor sufficient for their existence. A major function of legal rights is to accommodate third-party adjudication and enforcement. In the absence of these safeguards, rights may still be valued, but the economic rights to assets and their exchange must then be self-enforced. For example, squatters are less secure in their rights to the land they occupy than are legal owners; this is not because they lack deeds but because less police and court protection is expected for such holdings. Agreements based on goodwill are examples of exchange not supported by third-party enforcement. The third notion of rights is “natural” property rights, often expressed as “human rights” or “moral rights,” or even “social norms.”7 In a similar fashion, we can define these as Natural Property Rights: The individual’s authority under God or Nature or Society to exercise a choice with respect to some thing.

We take a broad understanding of natural property rights, and for us, they can include values that stem from a high power like nature or God but also include social norms and community standards. They could be formal and written, as in the Ten Commandments, or informal and generally understood. Like legal 6

7

The efficacy of a legal right depends on the willingness of the state to enforce them. This definition would not satisfy many legal scholars. Some would add that legal property is a state assigned right to real or personal property, something like land, a car, or a book, belonging to one person against the whole world (rights in rem). For us, we will focus on the distinction between rights under the law and rights through control (possession). Alchian and Allen (1977, p. 114) and Alchian (2007) did not recognize natural rights as having any meaning. For Alchian, human rights were simply rights held by humans. In one of his last works, he stated “... the purported conflict between property rights and human rights is a mirage. Property rights are human rights” (2007). However, this ignores the fact that human rights may not be actual economic or legal property rights. Both in scholarship and in practice, people speak of rights in a moral or natural sense. To say “I have a right to health care” is not necessarily a statement of economic or legal rights. These types of rights, however, are harder to observe, and therefore, are often nonoperational. Natural rights are also often ambiguous because people have different concepts of natural justice and morality. For some, the right to abortion is a natural right through the right of privacy. To others, it is a violation of the natural right to life of the unborn. Despite these difficulties, there is no denying that conceptions of social norms and moral values influence our choices, both directly and through support of legal rights.

Economic Property Rights

19

rights, natural rights either support or limit economic rights.8 Thus, as we can see, economic property rights functionally depend on legal and natural rights. When, during the same-sex marriage revolution that took place in the early twenty-first century, same-sex couples claimed that they “had a right to marriage,” they neither meant they were able to marry on their own (they did not have economic rights to do so) nor did they mean that the law granted them this right (they did not have legal rights to marry), but that it was a right under natural justice. The argument that any loving couple had the natural right to marry played a strong role in the eventual changing of the law, which enhanced the ability (economic right) of same-sex couples to actually marry. The effect of natural rights on economic rights often depends on how many hold to them. On their own, the small number of same-sex couples interested in marriage had little effect. It was not until many others came on board, who equated the natural rights of same-sex marriage to the natural rights of inter-racial marriage, that real change took place. In this book, we are concerned primarily with economic rights because our attention is on behavior and organization. It is because economic property rights are not absolute and can be changed toward some purpose that they are useful in the analysis of resource allocation. As mentioned, economic rights change through the actions of people, and these actions often depend on legal and natural rights. Indeed, legal rights are often a primary and significant factor in the creation and maintenance of economic rights because the state tends to enforce them. The past failure of economists to exploit the role of property rights in the analysis of behavior probably stems from two reasons. First, there is confusion over the various notions of rights. Second, there is a tendency to consider rights as either i) absolute, unchanging, and “good” or ii) absent, unchanging, and “bad.”9 Let’s consider the difference between these three notions of property rights with the help of the Venn diagram in Figure 2.1, where the set of rights to some 8

Locke (1698) in his second treatise defined the state of nature as being governed by the law of nature. This state, where individuals have freedom to control their possessions, is quite the opposite of a Hobbesian state of nature where life is “nasty, brutish, and short.” Despite the presence of economic property rights in Locke’s state of nature, these rights are weak because others can infringe on them and “enjoyment is very uncertain.” As a result, individuals are ... willing to quit a condition, which, however free, is full of fears and continual dangers ... and is willing to join in society with others ... for the mutual preservation of their lives, liberties and estates, which I call by the general name, property. (Locke, 2nd Tr., §123)

9

Thus, for Locke, a civil society requires the existence of legal property rights working with natural rights for the betterment of economic property rights. We return to this issue in Chapter 8 on institutions. This might stem from the great jurist, judge, and legal scholar William Blackstone who famously stated in his eighteenth century commentaries on the laws of England: There is nothing which so generally strikes the imagination, and engages the affections of mankind, as the right of property; or that sole and despotic dominion which one man claims and exercises over the external things of the world, in total exclusion of the right of any other individual in the universe. (Chapter 1, 2016)

Part I Conceptual Issues

20

FIGURE

2.1 Different definitions of property rights

thing of value, under each definition, is represented by a circle. Thus, the circle “EPR” is the set of economic property rights for some thing. Likewise, “LPR” and “NPR” are the sets of legal and natural property rights for the same thing. Significantly, the circles do not completely overlap. Let us consider the various intersections. In the central section A where the three circles overlap, the individual has the economic, legal, and natural rights over some thing. That is, the person is able, allowed by law, and morally justified to make a specific choice with respect to the thing owned. In some sense, this corresponds to the implicit assumption made in most neoclassical economic models where consumption is synonymous with ownership in every dimension. Many things in life fall into this category, such as breathing, or a trip to the store to buy a candy bar. Indeed, one would imagine that many issues of conflict, disagreement, and dispute would be absent in such a situation, and therefore, other things being equal, this would develop as norm or goal.10 In contrast, some type of rights are absent from all of the other intersections, and as a result some sort of conflict often arises. Consider section B, for example. Here, an individual has the economic and legal right to something but not the natural right. Some might consider abortion or landlords raising rents during a pandemic falling into this category. Both are legal and available in most jurisdictions, but many would consider them a violation of the natural right to life and the pursuit of happiness. Again, this points to the ambiguity in the concept of natural rights: They are subjective.11 In section C, an individual has the economic and natural rights but not the legal ones. This might apply to some religious sect that believes in polygamy

10 11

Although Blackstone wrote over two hundred years ago, his thoughts on property rights implicitly underlie much economic writing. This view of property perpetuates the idea of moral superiority for “absolute dominion.” Friedman (1994) also argues, but along different lines, that the rules and norms we observe tend to be efficient, just, and enforced by the state. Although across cultures and time we see common agreement in norms of general and specific beneficence; duties to parents, to elders, to posterity; concepts of justice, good faith, veracity, mercy, magnanimity, etc., it still remains the case that opinion differs on what constitutes the set of natural rights. For example, in the U.S., even after almost fifty years since abortion became

Economic Property Rights

21

and is tolerated by the state.12 They are able to have this type of polygamous marriage because the state allows it and they obviously feel it is right, but they do not have the legal right to the behavior. Section D, where an individual has the legal and natural right to something but not the economic right, is an interesting case because it applies to most crimes. For example, one might have the legal and natural right to walk through Central Park in New York City at 11:00 PM, but if attempted, a robbery might deprive them of the pleasure. Section E is quite the opposite situation. In this case, a thief has possession of some good and is able to use it, even though it is not his legal or natural property. Section F, where only legal rights are possessed, might apply to the notion of “cancel culture” – the practice of using social media and other means to limit or eliminate an economic and natural property right to income or participation. For example, J. K. Rowling, the famous author of the Harry Potter books, faced boycotts, online harassment, and petitions to limit her royalties over comments she (legally) made regarding the effect transgender rights could have on women’s rights. Finally, section G might apply to doctor assisted suicide, which many might consider a natural right, but in most jurisdictions they are illegal and unavailable.13 Unfortunately, the terms “rights” and “property rights” get used in multiple independent ways that often overlap. Because our concern is over behavior and the design of the distribution of economic property rights within which that behavior takes place, we want to focus on economic property rights – recognizing that they depend on the other two. EconomicPR = f (Legal PR, Natural PR, Social Norms, x), where x is a vector of factors other than legal rights, natural rights, or social norms that also effect economic rights. Unless otherwise noted, we use the term “property rights” in the remainder of the book to mean economic property rights.14 DIVIDED, INCOMPLETE , AND IMPERFECT ECONOMIC PROPERTY RIGHTS

The subject of economic property rights is nuanced for at least four reasons. First, the things we produce and consume are complex because they are almost

12 13

14

legal, only 60% of Americans believe it is a natural right of the mother, and in June 2022, the U.S. Supreme Court overturned Roe v. Wade. There is such a community in Bountiful, located in southwestern British Columbia. Or consider the fictional character of Jean Valjean in Les Misérables who served nineteen years in prison for stealing a loaf of bread to feed his sister’s children during a depression. Victor Hugo clearly plays on the sentiments of most who would recognize the moral veracity of Valjean’s actions, even though they were illegal. In Chapter 8, we return to the concepts of legal and natural rights and argue that the collection of these rights are a useful way of thinking about institutions. Institutions, therefore, have an effect because they influence economic property rights.

22

Part I Conceptual Issues

always the collections of various attributes.15 Simple products like toilet paper vary in terms of weight, bulk, stretch, tensile strength, brightness, and softness. Fruits and vegetables have, among other things, volume, count, weight, taste, freshness, and nutrients; a power tool like a table saw has components made of various materials, design, horse power, amperage, and safety features; a large building might have hundreds or thousands of attributes. These attributes also vary from one specimen to another: Not all apples in the bin are the same, nor does each table saw of a given brand have the same longevity or quality. Attributes are difficult to measure, and some are more difficult to measure than others. This means that one does not always fully know what is owned. Second, property rights are not a monolithic single thing; there are different types of property rights, not just a single generic one. As mentioned, there are rights of enjoyment, transfer, exclusions, etc. These different types of rights are often “bundled” together, but the specific bundle of property rights held over one good might be very different from the specific bundle of rights held over another good. In many instances there might be little standardization in the bundle of rights we observe. Multitudes of property rights exist with respect to a commodity or asset, and the scope of ownership can be described by what actual set of property rights are held by an individual. Having the right to enjoy an asset is different from having the right to earn income from it, and it is still different from having the right to transfer it or exclude others. Sometimes the owner of a commodity might possess all of these rights, other times not. Third, economic property rights involve their strength. From its definition a property right is a matter of the expectation that any given decision with respect to some attribute will be carried out. Except for abstractions, economic property rights are never a dichotomous “zero” or “one” in terms of this expectation. Finally, not only are there issues around what thing, what right, and to what extent is something owned by a given individual, but property rights ultimately are distributed across a population. The spread of property rights across one group might be very different to the spread across another group. Divided Property Rights To focus on divided ownership, we start by assuming there exists a single “generic” property right in the possession of a single individual over a commodity that has many attributes. This is a typical neoclassical assumption, where an individual completely “owns” some good that has multiple characteristics. When a single individual holds the property right over all of a commodity’s attributes we say that the property right is undivided. When a 15

The notion of commodities having attributes goes back to Becker (1965) and Lancaster (1966). However, Barzel (1977, 1982) first discussed them in the context of property rights. Alchian (1977) discussed the existence of money as resulting from the difficulty of measuring good’s attributes, and North (1990, pp. 30–32) built his discussion of institutions on the foundation of hard to measure attributes.

Economic Property Rights

23

single individual only owns the property right over some of the attributes and the rest are either owned by others or in the public domain, then the property right is divided. To be specific, assume there is a parcel of land called Blackacre, and it is characterized by J attributes indexed j = 1 . . . J. For example, Blackacre has a certain acreage and given location; a terrain and elevation; soil quality made up of soil types, drainage, nutrients, and moisture content; and other things might be tied to the land, such as trees, buildings, or other infrastructure. There are N people who are potentially involved as owners of Blackacre, and these people are indexed n = 1 . . . N, for the moment we will only consider the property rights for the single person n. Finally, for the moment, assume that there is only a single generic property right that can be made with respect to Blackacre, and this is denoted R. We will define the property rights for individual n using the following matrix:16 R ⎞ bn1 ⎜ . ⎟ J ⎝ .. ⎠ ⎛

bnJ where bnj is the probability measure of the strength of the specific property right R, held by person n, for attribute j. For simplicity momentarily suppose that this probability only takes on the following two values.  1, if attribute j is owned by person n; n bj = 0, if attribute j is not owned by person n. The probability bnj might equal zero because some other individual owns that attribute, some other individual always steals that attribute, or that attribute is unowned and is in the public domain. Using these concepts, we define an undivided property right as: Undivided Property Right: Individual n’s property right extends over all of the asset attributes.17

Thus, undivided property rights over Blackacre means that one individual (e.g., person n) owns every attribute of Blackacre (bn1 = 1 . . . bnj = 1), and no one else owns any of the land’s attributes. Person n has full control over every aspect of Blackacre. When Blackacre’s attributes are owned by multiple people (and we will spell out what is meant by multiple ownership below), or in the special case where some of the attributes are in the public domain and owned by no one, the property rights to Blackacre are then divided.18 Below are two possible 16 17 18

The matrix notation we use is for presentation, not analysis. In the case of all or nothing ownership, undivided ownership means j bnj = J. Divided ownership in this context would mean that some of the probabilities bnj ’s would equal zero, and j bnj < J. The idea that each attribute of a commodity or asset can be owned by

Part I Conceptual Issues

24

cases of the single property right for person n, assuming four attributes. In case (a) he has undivided ownership and in case (b) ownership is divided. R ⎞ 1 ⎜1⎟ ⎜ ⎟, J⎝1⎠ 1

R ⎞ 0 ⎜1⎟ ⎜ ⎟ J⎝0⎠ 1

(a) Undivided

(b) Divided

⎛

⎛

It is common for economic property rights to be divided, especially for complex things with many attributes. Whether or not ownership is divided is a matter of choice, and division exists because the net gains from exchange and production can often be increased if the nominal owner of the commodity transfers subsets of the commodity’s attributes to others while retaining the rest. Examples abound. In a large building, the occupants might own the right to the floor plan of a given unit and decide where certain walls go, but other individuals own the right to control the structural walls that support the building. In the case of any sale subject to guarantee, the original seller retains rights to various components of the good’s quality beyond the date of purchase and is expected to fix any failures. Indeed, all exchanges that are beyond “buyer beware” result in divided property rights where two or more individuals own distinct attributes of the same commodity. The case of rental agreements is interesting because now some rights are divided across time. During the rental period the renter holds rights over some attributes of the commodity, but once the agreement expires the ownership over the attributes reverts to the original owner. As mentioned, the residual is an important attribute that results from the exploitation of a commodity through exchange or production. Even for relatively simple commodities, the ownership over the residual might be divided; that is, several individuals share in ownership of the residual. Consider a firm’s photocopier. If the firm has a service contract for the copier, then the firm owner does not have full economic rights over the copier’s residual because he is not the only party that gains when the copier performs well and loses when it does not. The service supplier is a residual claimant of the servicing operation, gaining if it provides good service or service at low costs, and losing if the service is poor; the servicer is thus a part owner of the copier. Among other partial owners is the copier manufacturer, which is liable for certain damages the copier may cause. Thus the residual is divided among several potential owners.19

19

separate individuals was first noted by Alchian (1965), and elaborated on in Barzel (1982) who also noted that property rights in practice are almost always divided. Posner (1992), too, noted that ownership can be divided. Divided ownership refers to attributes owned by different individuals and should not be confused with “shared ownership.” Shared ownership means that different individuals share

Economic Property Rights

25

Incomplete Property Rights In defining divided ownership, we assumed there was only one generic “property right” to the commodity, but as mentioned in the discussion of what property rights are, there are many different types of rights over commodities and different sets of rights can be bundled together. The extent of one’s property rights over a commodity or thing is called completeness. Individuals seldom are in possession of the universe of rights to any given thing, and so property rights are often incomplete. In discussing the extent of completeness, we will use the term “scope” of rights. An increase in scope means that a single person possesses more of the rights to a commodity.20 To focus on incompleteness, assume that Blackacre is simple and contains only one attribute, J (say acreage), but there are R feasible rights associated with Blackacre, indexed r = 1 . . . R. For example, Blackacre can be sold, leased, put into various types of production, and others can be excluded from traveling across, above, or below it, and so on. In this case, the property rights held by individual n would be represented as J



bn1

R ...

bnR



where bnr is the probability strength of a particular property right Rr , held by person n, for the attribute acres. For the moment, once again assume that the values of bnr take on only the values (0, 1), depending on whether individual n owns that particular right or not. Incompleteness expresses the extent to which these different property rights are held by one individual. If an individual holds all of the property rights over the commodity, then the economic property right is complete. Complete property rights is a theoretical benchmark and is defined as: Complete Property Rights: Individual n’s property rights include all of the feasible rights of the commodity.21

The number of feasible property rights are obviously limited by simple facts of nature. If some wood was consumed yesterday by burning it in a fireplace, there are no choices to be had over the wood today – the wood doesn’t exist. Likewise, the choice to leap over tall buildings in a single bound is not in the feasible set of choices for mere mortals. Despite limitations on choices forced by nature, we will not consider these as cases of incomplete property rights. Incompleteness refers to the situation where feasible choices are held by different people (or no one).

20

21

control over the same attributes (perhaps all of them) and relates to imperfect ownership discussed below. Thus, when an individual in possession of two rights to an asset comes into possession of three, we will say the scope of property rights has increased rather than the completeness has increased. The term “complete” is useful mostly to describe the benchmark case of complete property rights where the individual possesses all rights to the commodity. In the case of all-or-nothing ownership, complete property rights mean that r bnr = R.

Part I Conceptual Issues

26

Below are two possible cases of property rights for person n, assuming there are four different types of property rights over Blackacre acreage. Suppose the first right was the right of exclusion to the airspace above the land. In case (a) person n has complete ownership over Blackacre. Of all the different types of property rights that could be had, he possess all of them, including the right to the airspace. In case (b) person n only possesses two rights, and so his rights are incomplete and do not involve the right of exclusive airspace. J



R 1 1 1

1



(a) Complete

J



0

R  1 1 0

(b) Incomplete

Like divided ownership across attributes, incomplete property rights are common. The various cards in one’s wallet may seem to be completely owned, as in “this is my credit card,” but these and other cards have limited uses for the person possessing them. For credit cards there are legal spending limits and restrictions on selling the card. Even within the spending limits, some sellers of high valued items will not accept payment by credit card to avoid the fees. These rights are not in the public domain; they are held by the bank issuing the card and the seller of the high valued item. Returning to the case of the copier, we see that ownership over it is not just divided but also incomplete. The firm has the right of making copies for business purposes, but the employees who are able to put the copier to personal use without charge also own an economic right over it. Although the firm is the legal owner of the copier, employees have some scope of economic rights because it is too costly for the firm to prevent the employees from making personal copies free of charge. If we recognize that Blackacre has both multiple attributes and multiple feasible rights, then the economic property rights over Blackacre for person n is described by the matrix Bn ⎛

bn11 ⎜ . Bn = J ⎝ .. bnJ1

R ... bnjr ...

⎞ bn1R .. ⎟ . ⎠ bnJR

where each element bnjr is the strength (measured as a probability) of the specific property right Rr , held by person n, for attribute j. That is, each element bnjr , is the expectation by person n that his choice over attribute j will be exercised. Of course, for a given entry, such a right may not exist, may be held by someone else, or is in the public domain, and the probability would be zero. Like divided ownership, the number of rights held by a single individual is a matter of choice over which owners maximize, and often the set of attributes held by an individual is related to the set of rights owned over those attributes. That is, divided ownership is often correlated with incomplete ownership.

Economic Property Rights

27

Indeed, the relationships between attributes and rights can become so standard that often it is hard to distinguish between the concepts of divided and incomplete ownership. For example, the set of property rights over a house is often divided in a way very similar to the set of rights over the land that the house is resting on, and when someone states they “own a house” it is commonly understood that the division of ownership for the land underneath is the same as for the building on top.22 As we will elaborate in later chapters, incomplete property rights often take the form of restrictions on one or all of the divided owners in order to enhance the total value of ownership over the given commodity. For example, suppose some attributes of a commodity are most efficiently owned by multiple parties in the form of common property. Since common property creates incentives for the suboptimal use of the attributes, it might pay to restrict the owners’ choices over use and transfer of the commonly owned attributes to mitigate these problems. In the case of the copier, restrictions on the ability of employees to use of the copier for private copies (or restrictions on who is allowed access to the copy room) can enhance the value of the copier and raise the net wage of the employees. Incomplete property rights also arise from restrictions on legal rights, as in the case of inalienability. Inalienability is the limited legal authority to carry out certain choices of ownership, such as transfer or use. Some commodities can be given as gifts but not sold (e.g., children through adoption), some things can be sold, but not given away (e.g., assets within an insolvent estate), and some uses may not be legally permitted (e.g., digging too deep in a yard with gas lines). When private ownership leads to socially poor outcomes, such limitations make sense. For example, those willing to pay the most for adopted children might wish to employ them as child slaves. Andolfatto (2002) argued that borrowing restrictions on social security entitlements reduced vagrancy and social squalor by preventing extremely impatient people from consuming all of their future income early in life. Allen (2012) argued that the Crown prevented naval captains from selling their officer commissions because those willing to pay the most would only seek merchant ships as prizes and never attack the enemy. Imperfect Property Rights Economists commonly make the assumption that the strength of property rights is all-or-nothing – as we just did in the last two sections. Thus, until now the elements of our property right matrix have only had the values zero or one; that is, an attribute was either owned or not. This all-or-nothing strength characteristic of property rights hides the most important characteristic of property rights: imperfection. 22

In contrast, someone who rents a room in the house does not possess the rights to the land, and no one would confuse “renting a room” with “owning the land.”

28

Part I Conceptual Issues

Property rights are defined in terms of an expectation, and in reality the probability that a choice will be carried out is virtually always less than one. This means that the very concept of an “economic owner” is necessarily more nuanced than that of a “legal owner.” A legal owner of a commodity is the one with the legal authority or entitlement to make choices with respect to that commodity, but in reality there is only a probability that the choice will come to pass. Others who are not the legal owner might also have some positive expectation that their choices over the same commodity will take place. This other person is also an economic owner. Returning to the copier case again, those employees printing off their annual Christmas letter on the company copier are partial economic owners of the copier but not legal owners. The level of this probability, or the extent to which one expects a choice to be carried out, defines the strength of the property right.23 It is this characteristic that is essential for an understanding of transaction costs and organization because individuals can take actions that influence the strength of their property rights, and these actions relate to the concept of transaction costs. As another theoretical benchmark, when a decision is carried out with certainty then the property right is said to be perfect. This is the implicit assumption that traditional neoclassical economics makes, and which we assert is seldom ever reached. With respect to the matrix Bn , which describes the property rights for a given person, a perfect property right for the rth right and the jth attribute means that the probability bnjr = 1. When bnjr < 1, then the right over that attribute held by person n is imperfect. We define the perfection benchmark for an individual as: Perfect Property Right: The individual’s choice with respect to an attribute is carried out with certainty; that is bnjr = 1.

The strength of property rights always comes down to a matter of enforcement in establishing the property right to begin with, and then maintaining that right. Issues of enforcement arise for many reasons, but there are three important cases.24 First, complex commodities often have simultaneously divided and incomplete ownership, and these multiple owners can infringe on the rights of each other. For example, in the case of Blackacre the legal landowner who controls many attributes about the land might rent to a farmer who then temporarily controls the level of soil quality. The farmer has a legal right to use the soil, but this access also allows him to excessively exploit the soil to his own benefit at the expense of the legal landowner. The presence of multiple economic 23 24

We will use the term “strength” to describe the level of imperfection throughout the book. It is always tempting to assume that property right strength is exogenous. For example, Besley and Ghatak (2010) assume that property rights are “insecure” because of an exogenous threat of government expropriation. This turns the problem into a purely neoclassical one where the government threat is essentially a tax on effort to produce.

Economic Property Rights

29

owners with access to the land leads to problems of infringement on many land attributes because the landowner finds it too expensive to enforce his legal rights to those attributes. Second, complex commodities are often shared. Whereas with divided ownership different people own different attributes of the same commodity, shared ownership is where different people own the same attribute in some shared fashion. There are shared spaces and commodities all over, and those people who are shared owners often have access to every attribute of the commodity. The sharing arrangement might be formal and legal or informal and based on social norms. With Blackacre the landowner might share the crop with the farmer, each contractually receiving 50% of the crop. However, the farmer at harvest has access to 100% of the crop and might actually take 60% because the landowner is again unwilling to enforce his property right to the full extent. When commodities are shared everyone involved might attempt to capture more than their agreed upon share. In both of the above cases property rights were imperfect because numerous people had legal access to the commodity and its attributes. However, property rights are also imperfect due to outright theft. One might expect to exercise some choice over a commodity or one of its attributes, but discover that the thing has been taken. Given that the threat of theft is almost always present to one extent or another, property rights are almost always imperfect, and owners spend resources to protect them from theft. This protection is a matter of enforcement and choice, and the unwillingness to protect fully, leads to the imperfect property right. Thus, property rights are imperfect because they must be established and maintained through some enforcement mechanism against other people. As we can see, the level of perfection is a matter of choice and depends on how strongly an individual maintains their right, the extent others (individually or collectively) try to infringe on an individual’s right, and the extent other third parties (either through the state or other means) encourages and enforces the right.25 The Distribution of Property Rights To this point we have described the property rights held by a specific individual. The last step is to describe property rights across a population. We define the collection of all the individual property rights over a specific commodity as the distribution of property rights for that commodity. If we return to our example of Blackacre and assume there are N potential owners, then the final distribution of property rights over Blackacre can be described as the collection of the individual rights: 25

One different reason for imperfect property rights is because nature interferes with the ability to make decisions. One wishes to eat the strawberries in their patch, but discover rabbits got their first. The role of nature is important and discussed in the next chapter. However, we exclude from the definition of transaction costs actions taken directly against nature.

Part I Conceptual Issues

30

⎛

b111

⎜ . J ⎝ .. b1J1

R ... b1jr ...

b11R

⎞

.. ⎟ . ⎠ b1JR

⎛ ...

bn11

⎜ . J ⎝ .. bnJ1

R ... bnjr ...

bn1R

⎞

.. ⎟ . ⎠ bnJR

⎛

...

bN 11 ⎜ .. J⎝ . bN J1

R ... bN jr ...

⎞ bN 1R .. ⎟ . ⎠ bN JR

where each matrix describes the rights held by a specific individual over Blackacre.26 By way of an illustration on how to interpret this description of property rights, suppose there were only three people (1, 2, 3) involved with Blackacre, which has just two attributes (minerals (m), and acres (a)), and there are only two property rights (exclusion (E), and use (U)). Furthermore, assume some arbitrary values of bnjr . Then one distribution of property rights could be: An Arbitrary Distribution of Property Rights Person 1 acres minerals



E 1 .5

U

1 , .6

Person 2

E 0 .25

U

0 , .1

Person 3

E U

0 0 .25 0

In the core neoclassical model, it is assumed that all goods have one attribute, one universal all-purpose right, and are owned perfectly. In the current illustration of Blackacre, “acres” almost fits this case. Person 1 owns the acres completely: There are two property rights to Blackacre (exclusion and use), and person 1 is able to exercise both of them alone. Person 1 also owns the acres perfectly and is able to exclude all others from infringing on his acres and stop them from using them. Persons 2 and 3 have no property rights over the acres of Blackacre. In this example the mineral attribute describes a more complicated and typical case. Consider first the property right over exclusion on Blackacre, which is spread across all three parties. Perhaps Person 1 is the legal owner, but he finds it too costly to keep the other two from accessing his minerals through tunnels. Note that even though every individual has an imperfect property right of exclusion, the fact that the probabilities sum to one does not mean this right is perfectly held collectively! What we can say is that Person 1, perhaps because he is the legal owner and can rely on some state enforcement, has the stronger economic property right compared to the other two. With respect to the property right to use the minerals we see that there is also imperfect property rights spread across two people, but this time the sum of the probabilities is less than one. In this case the distribution of property 26

It is tempting to want to add up the strength probabilities bnjr across people, but this has no meaning without understanding the context for their values. The strength of a property right is rooted in an individual, and three people with bnjr = 1/3, n = (1, 2, 3) is not the same as one person (say n = 2) with a perfect property right, b2jr = 1.

Economic Property Rights

31

rights is more concentrated, and the strength of Person 1’s property over use is better than over exclusion (.6 > .5). The sum of the probabilities is less than one, and therefore some amount of the minerals is unowned by anyone. This simple example shows that economic property rights can be described in terms of division, incompleteness, and imperfection – both at the individual and societal levels. Once again, we want to drive home the idea of thinking about property rights as a “distribution” of rights on multiple dimensions, and to think of this distribution in terms of the collection of all the individual rights (Bn ), recognizing that the strength of each right can range, in principle, from zero to one. We see complicated distributions of property rights all around us, even though we colloquially refer to ownership in simple terms. For example, return to the case of a house on a city lot to which a homeowner might casually say “I own this house.” However, under the right of “use” there are attributes of the home the owner controls (like the temperature inside) and ones that he does not control. The homeowner might want to park three broken cars on blocks on the front lawn but be prevented from doing so through zoning restrictions, or the homeowner might want to skateboard on his paved driveway but find that his neighbor’s tree roots have encroached on his land and raised the asphalt. Thus not all use rights of the property are owned by him and none of them are held perfectly. The state’s ability to impose and enforce zoning restrictions and the neighbor’s tree root encroachment imply that the state and neighbor are partial economic owners of the city lot – the property right to use the home is divided between the homeowner, the state, and the neighbor. There are other rights to the house, such as the ability to generate income from it, and once again some types of income generation (like a home office for consulting) are held by the homeowner, and other ones, (like starting up a small restaurant) are not. In addition, there are other physical attributes of the home (like the gas lines), that are owned and controlled by others. Thus, the rights to the home are divided because the homeowner has no economic property rights over certain attributes. With respect to any combination of attributes and property rights over them it is also likely that ownership is imperfect. Children cut across the property as a shortcut and burglars are a threat because the owner finds it too costly and not in his interest to establish perfect rights of exclusion. This means that the children and the thieves are part (economic) owners of the home (but not the legal owners!). As stated, in the neoclassical economic model, goods are assumed to be one dimensional and rights over them are assumed to be completely and perfectly owned. In the real world, however, property rights are almost always divided, incomplete, and imperfect, and these realities describe the ability to make choices. If our choices are totally absent, then no property rights exist. Economic property rights, however, are not all-or-nothing, and people are not indifferent to the degree of property rights on any of the dimensions.

32

Part I Conceptual Issues

CONCLUSION

When the term “property right” is bantered about in both casual conversation, policy debates, and academic circles, not only is there little attention given to whether these rights are economic, legal, or natural, but the subtle – but by no means minor – aspects of property rights are almost universally ignored. Property rights over commodities are bundles of rights that get split, shared, and combined in many different ways across many different groups of people, and all in a world where commodities are not uniform. The ultimate distribution of property rights describes an equilibrium choice over to what extent rights are divided, bundled, and enforced. This chapter has described these specifics in detail and developed a nomenclature to help clarify exactly what is meant by economic property rights. We will develop an operational model of property rights, but it is essential that specific words mean specific things. Not developing a consistent language around property rights leads to a failure to understand what transaction costs are. To possess an economic property right is to be able to make a choice with respect to a commodity. An economic property right has a strength, which is measured in terms of a probability. The level of this probability is a matter of choice and depends on such factors as the legal and moral status of one’s ownership, the efforts made to directly measure and enforce the choice, and the incentives of all the other people who might interfere with the choice. This latter effect depends critically on how rights are divided across the attributes of goods and how the various specific property rights are spread out across people.

3 Transaction Costs

INTRODUCTION

In 1935, Sir John Hicks wrote on the demand for money, where he spoke of “frictions” that arose in the transfer of assets from one person to another. Although he did not use the term “transaction cost,” the union of this term and “frictions” was made and started to work its way into all sorts of applications beyond money. It was a natural marriage for economists because frictions are obviously present in the world, and they are easily grafted into any neoclassical model. Indeed, in his Palgrave Dictionary entry where Niehans (1987) defines transaction costs as frictions, he notes that “transaction costs are analytically analogous to transportation costs.” In 1964, Harold Demsetz – who was writing sophisticated papers on property rights – muddied the transaction cost waters by recognizing that a transfer of assets was actually a transfer of property rights. Thus, although Demsetz knew that there was more to transaction costs than mere frictions arising from a transfer of assets, he contributed to the idea that transaction costs only involved the costs of “exchanging ownership titles” (1988, p. 64). Therefore, according to Demsetz, there could not be transaction costs outside of a market transaction. They did not exist within an organization like a firm or a family.1 Nothing is more common in economics than to find a paper on transaction costs that treats them as some sort of friction to an exchange, and where the friction is independent of the distribution of property rights related to that 1

Demsetz was following Coase (1960) with this view. Coase (1960) used the term “the costs of market transactions” to describe what costs mattered for ownership in the context of trade. When describing the costs that mattered within a firm, he used the term “administrative costs of organizing.” Later Coase would refer to both costs as transaction costs, but Demsetz never changed his mind and it led to his ongoing misunderstandings of Coase. See Demsetz (2011) as an example.

33

34

Part I Conceptual Issues

exchange. This approach dominates in finance and pure theory, and is generally irrelevant for understanding organization.2 For the study of how ownership matters in any context, we require a notion of transaction costs that violates the Coase Theorem.3 This means that transaction costs must be related to property rights, which is almost impossible to do with a “black box” notion of property rights. However, the detailed description of property rights from the last chapter allows for a proper understanding of the nature and causes of transaction costs. The connection begins with an understanding of how property rights influences total wealth. ECONOMIC PROPERTY RIGHTS AND WEALTH

The Two Extreme Cases In order to develop a benchmark case, for the moment, we abstract from divided ownership and incomplete property rights and focus on imperfection – the strength of ownership, which we will also momentarily take as exogenous and ignore the cost of achieving a given level of property right strength. Therefore, we start with the case of a single generic legal property right over a single attribute Blackacre that is held by a single person. We’ll also begin with two extreme cases of imperfection: universal zero imperfect property rights and a singular perfect property right. A universal zero strength property right over Blackacre means that everyone has no expectation that any decision would be carried out with respect to Blackacre. The distribution of property rights for simple Blackacre is as follows: Person 1, Person 2, . . . Person N





 0 , 0 , ... 0 with the strength of property right equal to zero for everyone (including any potential thief). In such a case, no decisions would be made with respect to Blackacre because there is no expectation of a decision being fulfilled. There would be no point to bring Blackacre into production, and without production, there could be no exchange nor any consumption: Blackacre would simply exist in a state of nature, and all choices with respect to it would be pointless. If we extend the idea of universal zero property rights to all things in the world, then there could be no possession, production, exchange, or consumption for all things. This is difficult to imagine, but in such a world humans could not exist. Wealth levels would be zero. Thus, if we observe human life, 2 3

See Allen (2000) for a survey of this literature. Cooter (1982) shows that a frictional definition of transaction costs related to exchange is insufficient to violate the Coase Theorem. He mistakenly used this to claim that the Coase Theorem is false, rather than recognizing his definition of transaction costs was insufficient.

Transaction Costs

35

there must exist some degree of property right strength, there can never be a pre-property right state of human existence.4 If we move away from zero imperfect property rights and consider very weak property rights over some thing, we can see that opportunities for wealth creation are available, but they would be limited. Consider section D in the Venn diagram of Figure 2.1 again. In this situation, an individual held legal and natural rights, but not the economic ones to some thing. Perhaps this is a situation of a stolen car where the legal owner of the car has a natural right to the car he paid for, but the ability to choose how the car is used (the economic rights) is held by the car thief who is not in possession of the legal property rights. The original owner values the car the highest, which is why he was able to outbid others to buy it.5 As such, the thief should sell the car back to the legal owner to maximize the gains from trade, but imagine how such a transaction might take place. If nonpersonal contact between the two is successful and a payment is made to the thief (who still has possession of the car), it is likely that the payment will be stolen as well. If the legal owner is able to convince the thief to make an in-person spot transaction where the payment is made at the same time the car is returned, the thief suspects he will be arrested. It is not that ransom is impossible, but it is extremely costly for the participants. Simply separating the economic and legal rights to a commodity drastically reduces the strength of rights and can lead to the elimination of exchange and reduced wealth, and explains why ransom is so rare.6 At the other end of the strength spectrum property rights are perfect. In such a case, the strength of property right for one person is unity, and all others have no ability to make choices with respect to Blackacre – their property right strength is zero. If Person 2 was the legal owner of Blackacre, then in this case the distribution of property rights would be: Person 1,

 0 ,

Person 2, . . .

 1 , ...

Person N

 0

In this case, we know what the level of wealth is, a la Coase: it is maximized. If Person 2 is not the efficient owner of Blackacre he will sell, rent, or transfer in some way to someone who is. That new owner will then maximize the value of Blackacre. Furthermore, Coase and others showed that when a commodity like Blackacre is complicated and has many different rights associated with it, as long as these property rights are perfect, it does not matter that they are 4 5 6

We return to this point later in Chapter 10 where we discuss the formation of property rights. Of course, a pre-legal property right society can exist. There are some special situations where a thief might value goods more than the legal owners. We cover this in Chapter 10. Ransom is most likely in cases of stolen children, corporate information, or famous art work where there is a great difference in the willingness to pay between the original owner and the next highest demander. This raises the costs of resale in a “black market,” and provides an incentive to attempt trading with the original owner.

Part I Conceptual Issues

36

incomplete for any given individual. That is, it doesn’t matter if one person controls the soil of Blackacre and another controls whether it is fenced, the consequence is the same: Wealth remains maximized.7 Furthermore, the Coase Theorem holds when Blackacre has many attributes with divided ownership, as long as the property rights of each divided owner are perfect. Thus, we know from Chapter 1 that when property rights are perfect in terms of their strength, the Coase Theorem applies, along with all of the wealth and neutrality results that go with it. Thus, there is a spectrum of property right strength ranging from zero to one, and we know the level of wealth for the two endpoints: zero and some maximum. Wealth results from decisions, and when decisions cannot be implemented there is no wealth, and when decisions are fully implemented wealth maximizers make choices that maximize wealth. The Intermediate Case: One Optimal Owner Now assume there is a continuous functional relationship between wealth and the strength of property rights.8 To explore this relationship let us continue with the case of Blackacre having a single generic property right over a single attribute, and consider two simple distributions of property rights for a given exogenous strength level. In case (a) below Blackacre is owned by Person 1 who has a relatively weak property right with strength equal to .25, and Person 2 has no property right. Case (b) is essentially the same with the ownership reversed. Two Distributions of Property Rights Case (a) Case (b)

Person

1 .25

 0

Person 2 0

 .25

In case (a) assume that a joint wealth of $100 is produced, and in case (b) only $30 is produced. This is shown in Figure 3.1, along with the joint wealth levels of other strength levels for the two different ownerships. In this figure, joint wealth is on the vertical axis, and so we are not concerned with wealth distribution, per se. On the horizontal axis, the property right strength is measured at the individual level. 7

8

Cheung (1969) was the first person to show this in the context of share tenancy. In agricultural land contracts the farmer controls many aspects of the land, but not everything. Different contracts lead to different rights being spread across different people. Cheung showed that different forms of contracts (different distributions of property rights across people), all maximized the joint value of production when transaction costs were zero. That is, the Coase Theorem held when property rights were incomplete but perfect. We will not justify this relationship, but rather appeal to the large literature that has documented it. For the sake of argument, we’ll also assume this relationship is monotonic.

Transaction Costs

37

Wealth Max. W (Case a)

$100

W (Case b)

$30

0 FIGURE

.25

Perfection 1

3.1 Wealth and property right perfection I

The two dotted curves show the relationship between wealth and strength for the two different distributions of property rights over all potential levels ¯ of strength. When Person 1 is the owner, the relationship is given by “W”; 9 ˆ when Person 2 is the owner, the relationship is given by “W.” In case (a) where Person 1 has a weak property right of .25, he produces $100 worth of wealth. In case (b) where Person 2 is the owner and has the same level of weak property right, he is only able to produce $30. Although for both people wealth increases with the strength of their individual property rights, clearly Person 1 is a more efficient owner of the good at every level of property right strength. Person 1 may make different decisions compared to Person 2, or Person 1 may have human capital that is more complementary with Blackacre – either case leads to higher levels of wealth. With only two people, and with Person 1 ¯ would describe the dominating Person 2 in the use of Blackacre, the function W economically relevant relationship between property right strength and joint wealth. The Intermediate Case: Multiple Optimal Owners However, assume there were many other individuals who could also own simple Blackacre, and no one’s wealth function dominates over all levels of ¯ from property right strength. In Figure 3.2, we reproduce the wealth line W  Figure 3.1, but now show another wealth line W when Person 3 is the owner. If we assume that at a strength level of .25 Person 1 remains the efficient owner, then at that strength $100 remains the maximum amount of wealth that can be produced on Blackacre when there are many potential owners. However, suppose that when the property right strength is .5 (perhaps because the state 9

¯ and W ˆ are both positive for all levels of Our monotonic assumption means that the slopes of W strength. This means that wealth is always higher when the strength of property rights improves, and that individuals always prefer stronger rights to weaker ones, other things equal. Note that both wealth lines must have the same end points: when perfection is zero or one, it does not matter who the owner is.

Part I Conceptual Issues

38

Wealth $140 W

$100 W*

0 FIGURE

W'

.25

.5

1

Perfection

3.2 Wealth and property right perfection II

is now enforcing the legal claim) Person 3 happens to be the efficient owner because he now produces the largest joint wealth. How could it be that the efficient owner of Blackacre depends on the given level of property right strength? Perhaps Person 1 is large and strong and with weak property rights is able to physically defend the property, even though he may not be very productive at exploiting the land. Perhaps Person 3 is a better farmer, and when the state starts to enforce property rights he is the one who can generate larger amounts of wealth by exploiting this comparative advantage and leaving enforcement up to the state.10 In Figure 3.2, we define W ∗ as the upper envelope of all individual wealth functions. Along W ∗ wealth is increasing for two reasons. First, it increases because the strength of the property right is increasing. Stronger rights, on their own, increase wealth because optimal decisions are more likely to be carried out. Second, along W ∗ wealth increases because the efficient owner also changes as the property right strength increases. When property rights are just considered a monolithic black box, the mechanism by which “stronger property rights” leads to higher wealth is often missing. Here, we see an important second mechanism: Stronger property rights can allow those with a comparative advantage in production to pay more for the asset and become the owner. Umbeck (1981) provided an interesting example of changes in the efficient distribution of ownership as the level of property right strength exogenously changed in the context of the California gold rush. In the early days of the rush there was zero state presence and state enforcement of gold claims. Sometimes miners defended their claims on their own, but more often private mining associations were formed for defense and the allocation of claims was driven by the threat of violence between the members. In these early days, when the strength of ownership was low, the efficient owners of the claims were those who had a comparative advantage in violence. Later, when increased state 10

We return to this idea that the degree of specialization in production depends on the degree of property right strength, in Chapter 8 on institutions.

Transaction Costs

39

capacity in defining, measuring, and protecting claims was achieved and legal title to claims became stronger, the efficient owners of the claims became those who had a comparative advantage in mining, not violence. That is, the efficient distribution of property rights included a different set of people before and after the introduction of state involvement. If we abandon the assumption of a simple Blackacre, and assume it has many different property rights over various attributes, and we further assume that many degrees of division, incompleteness, and strength over the distribution of property rights becomes possible, then we can have a more general interpretation of Figure 3.2 and the W ∗ wealth function. In this general situation the maximal wealth function W ∗ remains the upper envelope of all the individual wealth functions for a given distribution of property rights. However, for any given level of property right strength, there are likely many economic owners of a given commodity because ownership is divided and incomplete for any given person. While moving along the W ∗ function towards stronger property rights the degree of divided and incomplete ownership might also change, and indeed, the individuals themselves might change. Thus there are several reasons for why stronger property rights lead to larger amounts of wealth – other things equal. First, there is the direct effect: when the owner’s decision is more likely to be carried out, wealth is higher because wealth maximizers make wealth maximizing decisions.11 Second, as property rights become stronger, individuals with a comparative advantage in wealth generation are more likely to become owners. Third, as property rights become stronger there is more likely to be specialization in terms of ownership over specific attributes (divided ownership) or specific types of property rights (incompleteness). The latter two reasons are often ignored in economic analyses. WHAT ARE TRANSACTION COSTS ?

Because wealth increases in the strength of property rights, stronger rights are always preferred to weaker ones, other things equal.12 But other things are not equal since strengthening property rights is costly. In terms of wealth maximization, it is net wealth that matters. Strengthening property rights is also a choice, and will be made only so long as it is worth doing so. It is useful to think of two types of methods used by individuals to establish and maintain property rights. The first is by direct efforts. Establishing property rights can directly take place through things like capture (first possession), 11

Anderson and Hill (1975) provide an example of this with the introduction of barbed wire on the frontier. Hornbeck (2010) empirically showed that barbed wire, through its ability to increase the strength of farmer property rights over their crops and animals, increased agricultural development in the American West. 12 For now we are ignoring aspects of the distribution of wealth and will return to this in Chapter 4.

40

Part I Conceptual Issues

exchange (in its many variations), or through theft. Likewise, the maintenance of property rights also takes on many direct forms, such as direct measurement, enforcement (both public and private), and use of violence. Direct efforts to establish and maintain property rights do not involve changes in the division or scope of property rights. That is, direct effort maintains the distribution of owners over the various attributes and what rights are held by each individual. Therefore, direct actions to strengthen property rights can be analyzed in a straightforward neoclassical fashion as is often done. More measurement, more supervision, more policing, and so on, means stronger property rights for a given division and scope of property rights. At the same time, the discussion shows a more subtle form in which property rights can be strengthened: change the mix of who owns what attributes and who owns what type of property right. In Figure 3.2, it was assumed that as the strength of property rights exogenously changed, there might be a change in optimal ownership.13 However, the causality can go the other way: different distributions of property rights can lead to different property right strengths because the various incentives of the parties involved to engage in establishing and maintaining rights changes. One distribution of property rights might lead to a law of the jungle situation (strength ≈ 0), while another might lead to tremendous wealth creation. When commodities are complex, the various types of restrictions on division and scope can limit the ability of others to capture property rights by altering the efficacy of particular measurements, enforcements, and laws, etc., and the analysis becomes more nuanced. Thus, the nature of the distribution of property rights – the particulars over who are the economic owners of a commodity – is a fundamental determinant in the creation of wealth.14 This influence of changes in the distribution of property rights on wealth is an implication of the economics of property rights. Indeed, it is this channel that makes the economic analysis of property rights distinctly not neoclassical. Strengthening property rights through direct actions like measurement, through designing a specific distribution of property rights to fit a particular circumstance, or by creating broad institutional constraints on personal choices is costly. These costly actions lead us to a definition of transaction costs.15 Transaction Costs: The costs of establishing and maintaining a distribution of economic property rights.

To put it another way, transaction costs are the costs of strengthening property rights. These costs include the direct costs of enforcement, protection against 13 14 15

Such exogenous changes likely arise over “institutional” changes, and this will be discussed in Chapter 8. Much of the recent work in development economics over the past several decades might suggest it is the most important feature in explaining the wealth of nations. This definition comes from Allen (1991).

Transaction Costs

41

stealing or other forms of infringement, and any indirect costs of designing and changing ownership structures that might improve property right strength. Actions taken to strengthen property rights will often involve foregone gains or deadweight losses. One way to avoid being robbed at night is to not walk down dark alley shortcuts and instead stay on well lit streets. There is no direct expenditure in walking under a street light, but the value of the lost convenience of taking the shortcut is a deadweight loss and is a transaction cost. Likewise, a particular type of contract might induce a set of choices that create deadweight losses, and these are transaction costs even though there may be no direct cash expenditures in choosing that contract. Hence, if an exchange never took place because the transaction costs of establishing property rights was prohibitive, the lost surplus of that exchange would be a transaction cost. One does not get rid of transaction costs by not transacting! We call this definition the “Property Rights” definition of transaction costs because it makes the relationship between the two concepts explicit.16 The definition conceptually began with Coase (1937) in his discussion of the boundary between the firm and the market – although Coase thought of these costs only applying to an actual market transaction. It was Cheung (1969), however, who began to implicitly link the Alchian idea of economic rights to the Coasean concept of transaction costs (Allen and Lueck 2018), but it took some time to actually bring the ideas together in a coherent fashion (Allen 1991). BACK TO THE COASE THEOREM

The relationship between property rights and transaction costs is of fundamental importance because transaction costs cause the Coase Theorem to fail in the real world. Recall that when transaction costs are zero, the Coase Theorem informs us that the property right distribution is irrelevant for the final allocation of goods and wealth levels. When transaction costs are positive, however, then property rights are imperfect, and different distributions of property rights in terms of division and scope matter for the ultimate level of wealth. Wealth maximization implies that the property right distribution chosen determines a wealth level that lies along the W ∗ wealth function. The choice of distribution depends on the transaction costs associated with establishing and maintaining a given distribution of property rights. Therefore, transaction costs are necessary to understand the equilibrium distribution of property rights. As distinct as transaction costs are, they also are quite ordinary in the sense that they are fixed or variable, sunk or avoidable – transaction costs are costs. This means that transaction costs can be described by a cost function, with all of the meaning that that entails. It also means that the concept of transaction 16

See Allen, (1991, 2000). For similar, but often implicit, definitions, see Cheung (1969, p. 16), McManus (1975, p. 336, and 1972, p. 37), Jensen and Meckling (1976, p. 308), Barzel (1985, p. 8), Goldberg (1989, p. 22)) and Alchian and Woodward (1988, p. 66).

Part I Conceptual Issues

42

MC'

$

MV'

MC

MV

0

Wealth=0 FIGURE

PR*

PR' 1

PR Perfection

Wealth Maximized

3.3 Optimal property right strength

cost is operational. For example, when the cost of measuring a commodity falls within an exchange, it is more likely to be transacted in the market than within a firm. To consider the optimal level of property right imperfection, let us return to the simple Blackacre case where we assumed undivided and complete ownership, and assume that a transaction cost function has standard properties (e.g., rising marginal costs). This is shown in Figure 3.3. Figure 3.3 has rising marginal cost of perfection, and therefore given the definition above, the variable transaction costs in this case would be the area under the MC curve up to the chosen level of perfection. The initial, solid, marginal value function (MV) is assumed to be zero when the property right is perfect. Under such a circumstance, the net wealth, that is, the level of wealth net of the transaction costs, would be maximized at PR∗ . This necessarily means that the “gross” level of wealth is not maximized because no one finds it worthwhile to gain the entire potential of “their” asset through perfect rights. In other words, when transaction costs are positive, property rights are imperfect, and first-best wealth is not maximized. Had some other person exogenously owned Blackacre, the level of wealth would have likely been different, and therefore the Coase Theorem neutrality result fails as well. If we assume that the commodity is complex and that the MV function comes from the upper envelope of the maximal wealth function, W ∗ , then the entire distribution of property rights in terms of who owns what attributes and with respect to what rights could change as the degree of perfection changes. Once again, this means that the Coase Theorem results break down if the equilibrium level of strength is less than 1. The Coase Theorem only applies when transaction costs are zero.

Transaction Costs

43

Among other cases, transaction costs clearly arise in the context of exchange. As an illustration, consider the transaction costs associated with the National Football League’s (NFL) draft of college football players. By drafting a player, a team acquires the exclusive negotiation rights for his services, inclusive of the right to transfer this player to any other NFL team. Every year the thirty-two NFL teams select eligible college players in a predetermined sequence. It would seem that the team with the right to, say, the twentieth selection would choose the player among those not yet drafted whose net value to any team is highest. The probability that the team with the right to the twentieth selection will also be the one placing its highest value on any of the remaining players is the same as any other team’s, that is, one in thirty-two. Were the costs of exchange among teams zero, the odds of that player being traded would then be thirty-one in thirty-two. The observed trading frequency of newly drafted players, however, is much lower than a zero transaction cost model would predict. The transaction costs to trading appear to be considerable. As a consequence, in that case some exchanges that otherwise would be attractive may be forsaken because of such costs. Returning to Figure 3.3, had the MC function been zero, that is, had the transaction costs been zero at the margin (and any fixed costs not too high), then property rights would be perfect, wealth would have been maximized, and the distribution of rights irrelevant. This, again, is the Coase Theorem: If transaction costs are zero, property rights are perfect. Hence, the transaction cost definition above is both necessary and sufficient for the Coase Theorem. Transaction costs are the only factor we need to consider to explain the optimal distribution of property rights. Figure 3.3 helps us understand a few other things. First, in Figure 3.3 the dotted marginal value curve MV  intersects the marginal transaction cost function at a high level of perfection close to 1. In this case, the value of very strong property rights is so great that property right strength is very high even though the transaction costs are positive and large.17 It is also possible that there is some fixed transaction cost, but the marginal transaction costs are zero, and in this case perfect property rights are the equilibrium outcome even though transaction costs are positive. In other words, the Coase Theorem logically only works one way: If transaction costs are zero, then property rights are perfect; but if property rights are (close to) perfect, transaction costs may still be positive and the Coase Theorem not hold. This “one direction” logical feature explains some odd findings in the small empirical literature on the Coase Theorem. To correctly test the Coase Theorem would involve finding a zero transaction cost world, have a compensated alteration in property right structure, and see if the equilibrium allocation was the same. Such an experiment has never been done – presumably because it can’t. Rather, researchers find some particular market where property rights 17

Except in the most contrived cases imagined, it is plausible that the marginal costs of perfection would not justify ever having PR∗ = 1. This is why we claim property rights are never perfect.

44

Part I Conceptual Issues

are very strong, and then look at allocations under different property right distributions. Often, even though transaction costs are not zero evidence is found for a neutrality result; that is, it looks as though the Coase Theorem holds. For example, Cymrot et al. (2001) found an “irrelevance” of property right in the context of baseball free agency, not because transaction costs are zero in baseball, but because they are low and the value of strong rights over valuable players is high. These types of exercises are technically not tests of the Coase Theorem, but rather examples of where the real world is simply close to the neoclassical ideal in terms of the expectation people have with respect to choices made. Indeed, given that the conclusion of the Coase Theorem logically follows from the assumption of zero transaction costs, any failure of a test only informs us that the underlying assumption has been violated and transaction costs are positive. NO - FAULT DIVORCE

To highlight the various concepts we have discussed thus far, and to also see how they have played out in a particular real world context, consider the nofault divorce revolution that swept through the western world in the late 1960s and 1970s, and continued to regulate the lives of married couples. To the extent that divorce was ever historically allowed, it had always been granted after a “fault” had been committed by either the husband or the wife. Faults were the “grounds” through which the divorce took place and were specified in the law, and although they varied from one jurisdiction to another, they commonly included adultery, cruelty, and criminal conviction. When a fault had taken place, a spouse could petition the court for a divorce based upon proof of the fault. One of the realities of fault divorce was that it was often hard to prove in court that a fault had been committed, especially if the guilty party didn’t wish to be caught or was unwilling to confess. As a result, couples often engaged in the production of evidence, and would then perjure themselves in court. Such behavior required the agreement and cooperation of both parties, and so fault divorce has often been described as “mutual” divorce. Canada, in 1968, became the first country in the world to switch from this fault based system to one that became known as “no-fault” divorce. In 1969, California was the first U.S. state to switch, and others followed, with South Dakota being the last to switch in 1985. Indeed, over the 1970s most of the western world switched from fault to no-fault divorce. There is a wide range of laws that fall under the umbrella of no-fault divorce. In some jurisdictions new “no-fault” grounds are added to the old grounds. In others, the old grounds are eliminated and replaced by some type of irreconcilable differences, irretrievable breakdown, or incompatibility. What all no-fault rules have in common is that they allow divorce to be instigated unilaterally; that is, the claim of one party is sufficient to establish the ground for divorce. Not surprisingly, these laws are often referred to as “unilateral” divorce.

Transaction Costs

45

TABLE 3.1 Joint values married and divorced: Efficient marriage

Married Divorced

Husband

Wife

Joint Value

$50 $60

$50 $30

$100 $90

Becker et al. (1977) noted that the switch from fault to no-fault divorce had a “Coase Theorem” flavor. During the older fault period consent from both parties was mostly required, and this meant that the decision to proceed with a divorce rested on the party least wanting to terminate the marriage. One could say that the spouse least wanting the divorce possessed the economic property right to divorce. On the other hand, the move to no-fault divorce meant the grounds were unilaterally enacted and so the spouse most wanting the divorce owned the divorce instigation decision. Becker et al. argued that incentives to divorce depended on the value of the marriage and the joint outside options of the couple. Since these did not depend on the state of the law, the switch in legal regime should have no effect. Efficient marriages should remain together, inefficient marriages should fail, regardless; that is, no-fault divorce should have a neutral effect on divorce rates – it seemed like a nice application of the Coase Theorem. If transaction costs were zero, then, as Becker pointed out, the law on divorce grounds merely creates a starting position that subsequently determines the direction in which side payments have to go. Consider Table 3.1. Table 3.1 describes the payoffs for a given couple if married or divorced, when the marriage is efficient. That is, in this particular case the marriage is worth more ($100) than the joint value of the divorce ($90). This couple should stay together; however, it is also the case that the husband prefers a divorce to marriage because his wealth is higher when divorced ($60>$50). For the wife, the opposite is true, she prefers being married ($50>$30). If the couple lives in a fault regime, the wife owns the right to divorce and so the husband must pay his wife to agree to a divorce. The maximum he is willing to pay is only $10, but the wife requires at least $20 to consent to a divorce. The husband is unwilling to pay this amount, the wife does not consent, and the efficient result happens – no divorce. Had the couple lived in a no-fault regime, the husband would unilaterally file for divorce. However, the wife is harmed by the divorce and is willing to pay $20 to the husband to remain married. Since the husband only requires $10 to stay, the husband remains and there is no divorce – the same outcome as under the fault regime. If the numbers in the table change such that it is more efficient for the marriage to terminate, then that outcome happens regardless of the law. The divorce outcome depends on the fundamental economic realities (in this case the values married and divorced) and not the law under which the

Part I Conceptual Issues

0.0

Divorce Rate per 100,000 pop 100.0 200.0 300.0 400.0

46

1920

1960 1968 year The Introduction of No Fault Divorce Divorce Rate Trend

FIGURE

1940

1980

2000

Actual Divorce Rate

3.4 Crude divorce rate 1922–2008, Canada

parties bargain. If there are no transaction costs, the logical outcome of the Coase Theorem is unassailable. Of course, the real world is not characterized by zero transaction costs.18 Figure 3.4 shows the crude divorce rate in Canada from 1922 to 2008 (the last year divorce data was collected) as a thick line. In Canada, the grounds for divorce are a federal law and so the entire country switched to no-fault divorce in 1968 (shown as the thin vertical line in the figure). Over the course of the early twentieth century, the divorce rate had been low and slowly rising, and by 1968 there were just 55 divorces in Canada for every 100,000 people. In 1969 that number more than doubled to 124, and it continued to rise until in 1987 it was 360. That’s almost a seven fold increase in twenty years. Prior to 1968 the crude divorce rate had been increasing at a nonlinear rate. If this trend is continued along the dotted line, the crude divorce rate does not return to trend until forty years later. It is hard to look at a figure like this and see a legal neutrality result, even imagining controlling for other factors. Looking at the crude divorce rates of other countries that switched would show a similar pattern and so the question arises: What got in the way of bargaining that resulted in the increased divorce rate? 18

By the 1990s, a dispute over the evidence of the Coase Theorem prediction on divorce rates started and lasted for at least twenty years. Peters (1986) was the first large study test, finding no difference in U.S. divorce rates across different jurisdictions. This was challenged by Allen (1992) who found the result hinged on how three small states with ambiguous legal changes were coded. Wolfers (2006) put the U.S. debate to rest, finding that no-fault divorce led to a rise in divorce rates, but this effect faded away after 15–20 years. Still, other studies from around the world continued to find that the switch to no-fault divorce was not neutral (e.g., Aguirre 2019). Most conclude the Coase Theorem prediction is refuted.

Transaction Costs

47

No-fault divorce created a state mandated uncompensated transfer in the right to instigate a divorce. Whether someone acts on that change in right depends on the gains and losses of doing so. A number of factors influenced these costs and benefits. At the time of transition, there were quirks in marital property laws that had been on the books for decades, but only became binding with the introduction of no-fault divorce. For example, during the fault era a university degree was generally not considered marital property and therefore not subject to division at divorce. In some jurisdictions pension funds and insurance policies were not considered marital property. Some places made an automatic split of marital property 50–50, despite contribution, while in other places the courts made an effort to establish each spouse’s contribution to the marriage to determine who got what. In every case narrow legal rules often allowed one spouse to take advantage of the other spouse. If one party can leave a marriage and take many of the financial assets with them due to quirks in property rules, the simple bargaining discussed above breaks down. Perhaps the most important asset in a marriage are the children, and laws regulating support and custody also vary in terms of their ability to protect the interests of the various parties. On the one hand, the inability to perfectly enforce support payments for children and spouse allow the instigating party to avoid some of the costs of their actions. Hence, the private values of the party leaving the marriage can be out of line with the joint value of the marriage. On the other hand, some jurisdictions compensate too much in the other direction, and the party with custody can often take a disproportionate amount of the financial assets along with the children. In either case, the involuntary transfer of wealth causes a breakdown in bargaining. Many family assets may be indivisible or may be quasi-public goods (like children), making them difficult and costly to bargain over at the time of divorce. Given the physical difference between husbands and wives, and given the privacy in which they interact, violence is often a possibility. Violence may make renegotiating the terms of the marriage too costly, and an inefficient divorce or marriage may occur. Either party is capable of threats of violence in order to forcibly dissolve a marriage and enforce a property settlement that does not reflect the true contributions of the parties. Likewise, both parties can force a divorce by destroying the marital capital if they stay together by being abusive, irresponsible, and dissipating towards financial assets. Similarly, one party may be able to maintain a marriage through threats of force. Again, these factors get in the way of “Coase bargaining.” Finally, agreements based on a promise not to leave are essentially unenforceable in court, and the loss of a legal property right restricts the ability to bargain for the person least wanting to leave and can result in an inefficient divorce.19 This is particularly a problem for wives. Though wives make many 19

This last point is made by Brinig and Buckley (1998).

Part I Conceptual Issues

48 TABLE 3.2 Joint values married and divorced: Inefficient marriage

Married Divorced

Wife

Husband

Joint Value

$60 $50

$30 $50

$90 $100

contributions to a marriage, a major one is pregnancy and the rearing of children. Though a mother may also work, the presence of more than one child causes major disruptions in workforce participation, and hence a reduction in her financial contribution to the household. Because this contribution takes place early in a marriage, the wife makes a sunk investment in the marriage and places herself in considerable jeopardy. The husband, on the other hand, makes no such investment. In fact, a typical male income increases throughout his working life. Middle-aged husbands, then, can realistically expect a new spouse after divorce, while the same is not true for middle-aged wives. Under these conditions it is easy to see why the inability to enter a binding contract with the husband is detrimental to wives (Cohen 1987). In addition to this there is a reciprocal reason for increased divorce rates, namely, transaction costs under the old fault law allowed for inefficient marriages. For example, suppose the terms in Table 3.1 were switched to those in Table 3.2 such that the value marriage was 90 rather than 100. In this case, the wife wishes to remain married, but total wealth is higher if they divorce. Under the fault rule, if the husband wants the divorce he requires the wife’s agreement, but the wife may not agree if she believes the husband will default on alimony and the state will not enforce the divorce agreement. In other words, the potential costs of privately enforcing a separation agreement may prevent the agreement in the first place. All of these issues – inappropriate property laws, difficult to transfer assets, indivisibility in marital property or children, violence or threats of violence, imperfect enforcement of agreements, understanding what assets are at stake – create transaction costs. These sorts of costs are ubiquitous in the real world, and as a result, the actual distribution of property rights in play matters for the allocation of all sorts of marriage behavior. The switch to no-fault divorce took place in the context of a world of positive transaction costs. In such a case, there is no reason to expect any sort of neutrality to that legal change. CONCLUSION

Transaction costs are not “just costs” because they are the other side of the coin to imperfect property rights. In the neoclassical model, property rights are implicitly assumed to be perfect and transaction costs are assumed to be zero. Adding some type of friction cost to a neoclassical model only adds another

Transaction Costs

49

ordinary cost, and fundamentally does not change the model. Only when it is costly to establish and enforce property rights does ownership suddenly matter, and this is why transaction costs are so important. Transaction costs are those costs that arise from strengthening economic property rights – they are the costs of establishing and maintaining these rights, along with any deadweight losses that follow. If these costs are zero, then the Coase Theorem holds, the neoclassical model applies, and all forms of ownership are irrelevant. Clearly, these are an important category of costs. In Chapter 4, we examine what lies behind transaction costs and explore the consequences of a particular type of information costs.

4 Information Costs

INTRODUCTION

Information costs underly the long transaction cost literature.1 Humans are not gods, but mere mortals with different levels of ignorance. In an attempt to reduce their ignorance, people talk to each other about the things they trade and produce; they inspect and measure almost everything; and they consult experts over what to do. In trades, formal contracts are often made that spell out terms, including the possibility and consequences of future events. Information is produced, recorded, verified, and traded all of the time. Evidence of costly information abounds. Though its importance is recognized by everyone, the role of information leads to a great deal of confusion in the discussion of transaction costs and therefore property rights. Because the two ideas of transaction and information costs are connected, but are not the same, information costs are often confused with transaction costs and vice versa. In addition, information costs are often considered sufficient for transaction costs, which is also not true. Understanding the nature and implications of information costs helps in understanding transaction costs and, therefore, the economics of property rights. INFORMATION COSTS AND TRANSACTION COSTS

Consider the single brief statement Coase made in 1960 on the “costs of market transactions.” 1

Consider the following chain. “The coalescing of these rights has arisen, our analysis asserts, because it resolves the shirking-information problem of team production ...” (Alchian and Demsetz (1972, p. 783)). “The assumption ... of costless information of products, is the one allowing the Walrasian model to dispense with exchange costs” (Barzel 1985, p. 5). And “The costliness of information is the key to the costs of transacting ...” (North (1990, p. 27)). Information costs are simply the costs of acquiring information. When the information is quantified, it is called a measurement cost.

50

Information Costs

51

In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. (1960, p. 15)

Almost thirty years later, Niehans essentially repeated the same thing, parties must: find each other, they have to communicate and to exchange information ... goods must be described, inspected, weighed and measured. Contracts are drawn up, lawyers may be consulted, title is transferred and records have to be kept. In some cases, compliance needs to be enforced through legal action and breach of contract may lead to litigation. (1987, p. 676)

Returning to the definition of transaction costs in the last chapter (the costs of strengthening property rights), we can judge these claims. Clearly negotiation, drawing up a contract, inspection, investigation, and creation of reputation are all examples of transaction costs because they all involve establishing and maintaining property rights. One negotiates because some of the gains from trade lie in the public domain and economic property rights need to be established over them for the exchange to move forward. Likewise a contract is a means by which property rights are established over production decisions, and inspection and measurement are means by which established rights are maintained. Reputations are often used in addition to, or in lieu of, contracting to establish and maintain property rights; therefore, the costs of reputation are also transaction costs. These actions are necessary because of an information problem. All of them involve some amount of learning about the numerous attributes and their variations, and therefore involve mitigating an information problem. Negotiation, fraud, communication, and contract stipulation all come about because knowledge is limited and not common. Therefore, the cost of collecting information is a prerequisite for the existence of transaction costs; indeed, if information costs are zero, then there could be no transaction costs. Information costs are necessary for transaction costs. On the other hand, discovering who to deal with, informing people of an intent to engage, and announcing terms – in and of themselves – are not transaction costs.2 They are not means by which property rights are being established and maintained. They are purely information costs, like determining whether or not it is going to rain in the coming week. Information costs, therefore, are not always transaction costs. Steven Cheung colloquially defined transaction costs as “all the costs which do not exist in a Robinson Crusoe economy” (1998, p. 515), and this is a useful metaphor for thinking about 2

With a little imagination, any type of information costs could be construed as a transaction cost. For example, if “discovering who to deal with” is a matter of “discovering who to steal from,” then the information costs of discovery would be a transaction cost.

Part I Conceptual Issues

52

0 FIGURE

p

1

O

4.1 Sales for a given distribution of tastes

information costs. Crusoe was shipwrecked on a desert island and while he lived alone he faced many information problems: How was he to feed and cloth himself, and where were the dangers on the island? Even when his companion Friday showed up, Crusoe still had information costs that were not transaction costs. He might have wondered if he’d told Friday a story already, for example. However, it is the presence of Friday that leads to transaction cost problems. With Friday, Crusoe has to worry about the theft and abuse of his property. Information costs, therefore, are not sufficient for transaction costs. All kinds of behavior depend on information costs and not transaction costs: Certain kinds of unemployment, search, and clearance sales, for example, are events that require only costly information.3 Information Costs without Transaction Costs: Sales To drive home the idea that some situations involve information costs without transaction costs, consider the case of bargain sales.4 Suppose a retailer sells a simple, “single attribute shirt” that will be in fashion for two seasons. Tastes over this attribute vary across the population, and so there is a distribution of willingness to pay for the shirt. Each person’s willingness to pay for the shirt is given by θ , which is distributed over [0, 1]. This distribution is known to the retailer, and for simplicity the marginal costs of selling are zero. Figure 4.1 shows the distribution of tastes, and for a given price p, those willing to pay more will purchase. Sales are given, therefore, by the shaded area (equal to 1 − F(p), where F(p) is the cumulative density). If the retailer had only one period to sell, it would maximize revenues (profits given marginal costs are zero), by setting p = 50c/ . With two periods, the retailer gets a second chance to sell its shirts, but all that is remaining are what’s left over (F(p), the unshaded portion in Figure 3.1). Given a price of 50c/ in the first period, the optimal thing to do would be to set p = 25c/ in the second, and then throw away the rest in the following period when the shirts go out of fashion. Of course, the price in the first period would not be 3

4

Barzel (1977, pp. 292–294) pointed this out. If, by assumption, transaction costs were zero but information costs still existed, then some type of process can bypass any information problem: “... with costless contracting, it is possible to find distortion-free transactions which are perfect substitutes for the wasteful informational activities” (p. 292). A perfect contingent claims market or a perfect asset (bond) market means that any uncertainty can always be eliminated through trade across different states of the world. This is based on Pashigan (1988).

Information Costs

53

made independently of a price in the second, and it is easy to show that the optimal pricing strategy is to set p1 = 67c/ and p2 = 33c/ and then throw away or donate the bottom third. It is a relatively uninteresting problem, but it demonstrates that a pattern of pricing, namely predictable price reductions over time followed by a donation, results from an information problem alone. Had the information problem been eliminated and tastes still varied, there would have been price discrimination. Had there been no information costs and no variation in tastes (or competition among sellers), there would have been a single price in one period. There are no transaction costs in this analysis of sales, even though there are information costs. Information costs arise over the acquisition of knowledge, but for us a particular type of information is important: those that arise from determining the levels of commodity attributes. In Chapter 2, we stated that commodities are made up of numerous attributes, each with a distribution across specimens. Were the information costs associated with a given commodity zero, then this would mean that everything that is possible to know about its attributes would be known. This knowledge would not only apply to the full set of attributes (their levels and number) but also to who has the economic property rights over those attributes. Any infringement of this ownership would therefore also be known, and so no infringement could take place because every attempt at theft or capture would be known and punished to an extent that deterred it. With zero information costs, the threat of a sufficient punishment would always be adequate, and transfers would only take place through voluntary exchange and not involuntary theft. Thus, zero information costs lead to all interested parties in the commodity to possess full information of all its valued attributes, and therefore the economic property rights over a given commodity would all be perfectly owned. With full knowledge, there are zero transaction costs, and the implementation of any property rights distribution (including the optimal one) takes place freely. VARIABILITY AND ALTERABILITY

If information costs are necessary but not sufficient for transaction costs, then something else must be required to cause the latter to arise. As noted, the mere presence of information costs leads to risky events which can be eliminated through contingent claim contracts of one sort or another. In addition to costly information, some factor is required to eliminate the ability to write complete contingent claim contracts, and there are several proposals of what this factor might be. Knight (1921) first suggested a distinction between risk and uncertainty; uncertainty arising in situations where human behaviors prevented individuals from assigning meaningful probabilities to events and thereby eliminating the ability to contract over the uncertainty. Other suggestions included the notion of asymmetric information and opportunism

Part I Conceptual Issues

54 TABLE

4.1 Examples of variability and alterability

Variable Non-variable

Alterable

Non-alterable

Everything else: Apples, Diamonds, etc. Raw Elements: e.g., Helium

Earthquakes, hurricanes, Seasons Earth’s rotation, Speed of light

(see Akerlof, 1970, and Williamson, 1975, 1985). Asymmetric information is a sufficient (but limited) condition, while opportunism does the same in a more ad hoc, less economic, fashion. However, we build on the more specific idea that goods are complicated bundles of attributes and that all attributes contain two properties: they are variable and alterable. The need to be informed regarding commodity attributes shows that the real world source of transaction costs is a particular type of information problem. The distinction between variability and alterability can be thought of as those changes in a commodity’s attributes found in nature (variability) and those brought about by people (alterability). Table 4.1 provides some examples for illustration, and points to how ubiquitous both conditions are. Some things in nature do not vary and are not alterable by people, like the speed of light or the earth’s rotation. Other things in nature vary, but still remain outside the control of people, like the weather or seasons. In this latter case, there are two particular subcategories of variability that are economically important. Sometimes nature is random, as with earthquakes, and generates pure uncertainty. It is the uncertain variability in nature that is a critical component of transaction costs and imperfect property rights. In other instances nature creates variation, but it is predictable, such as in the case of seasons. Allen and Lueck (2002) refer to this last case as “seasonality.” Seasonality constrains neoclassical production (one cannot reap what is not sown), and although this plays a role in organization, this type of variation does not directly relate to transaction costs. Several things in life, and especially things in the natural world, do not vary in nature but are alterable by people. The raw elements, in their pure form, do not vary in nature. Helium, for example, is a noble gas that has a fixed atomic mass and density, two isotopes, and a fixed melting and boiling point in specific conditions. But helium can be altered. It can be liquefied, freezed, stored in various ways, and mixed with other gases. Despite the exceptions, most things in life that we deal with daily are both alterable by people and variable in nature. Indeed, it is difficult to think of things in our daily life that are not both variable and alterable. The critical feature of this joint presence, and thus a product’s quality, is that it necessarily presents a problem for all trading parties: what caused the final level of product quality, nature or humans? The presence of both variability and alterability

Information Costs

55

(and costly information about them) generates an uncertainty over the cause of product quality, and this creates an environment for transaction costs to exist. Suppose apples never varied in nature but could only be manipulated by a retailer. Could a merchant sell an altered apple and not be accused of cheating the customer? No, because any change in the quality of the apple is, by assumption, properly blamed on the seller. Sellers, knowing that they will be held accountable for the low quality apple, cease altering them in adverse ways and the exchange carries on as if there was full information. Likewise, if apples came in all different shapes, sizes, and insides, but were impossible to alter, then no suspicion of seller misbehavior would exist. All bad apples would be attributed to a bad draw from nature, and we are back to the insurance of risk problem: Consumers either self-insure by taking a random draw from the apple bin, or enter some type of contingent claim contract to avoid the apple risk. Only when both conditions exist and a bad apple is produced by both nature and the seller, can the seller engage in some type of behavior that benefits him at the expense of the buyer without the certainty of being detected. When the buyer discovers he has a bad apple, he is not certain if it came from a low draw from a high mean distribution or an average draw from a low mean distribution. As a result, the seller can escape blame for providing a low quality apple when it was actually his fault. That it is so difficult to think of examples of attributes that are non-variable or non-alterable implies that transaction costs are ubiquitous. When commodities contain attributes that are either alterable or variable, but not both, then transaction costs are ultimately zero. Both alterability and variability are needed in order for transaction costs to systematically arise and continue to exist, because these costs ultimately stem from the inability to distinguish between changes in product quality due to random events or non-random exploitation. Capture through Measurement and Sorting Recognizing that commodity attributes can vary and be altered without a buyer’s full knowledge, means that trust is not automatic in an exchange. One means of getting around a lack of trust is through measurement, which is the quantification of information. All parties to an exchange have an incentive to measure the attributes of the commodity when they do not trust each other, and measurement is a significant means of establishing and maintaining a property right. Measurement costs, therefore, are transaction costs that directly arise from costly information. However, there is a subsequent indirect transaction cost of capture that also arises. When, relative to their value, the commodity’s attributes are too costly to measure accurately, the result is they are not fully known to prospective

56

Part I Conceptual Issues

owners. But when the levels of attributes are not fully known to the parties involved, everyone has an incentive to expend resources to capture the attributes without paying for them. The effort to capture is also a means of establishing economic property rights over these attributes. Thus, positive information costs lead to positive transaction costs in the form of direct measurement costs, but also in the form of indirect efforts to capture attributes that remain unknown to other parties. At a cost, it is possible to obtain information of attribute levels and establish some degree of property rights over them. Because it is always prohibitively costly to measure commodities fully, property rights are not perfect, and the potential of wealth capture is always present. The opportunity for wealth capture is equivalent to finding property in the public domain. As viewed here, wealth lies in the public domain due to information costs, and individuals therefore, spend resources to appropriate it.5 The concept of “capture” is critical to transaction costs because, in contrast to a costless exchange, the original owner does not receive fully what the recipient expends. Whereas people always expect to gain from exchange, they also always spend resources on capture within a given exchange. It is as if people shake with their right hand to indorse generating a mutual benefit, while they guard their wallet (or pick the other’s wallet!) with their left hand. A common example of capture comes from the practice of sorting. The sale of cherries illustrates the phenomenon of wealth capture through measurement and sorting.6 To start, assume that a cherry buyer has decided on where to purchase, and is only determining how many cherries to buy from a given seller. Cherries vary in terms of quality, and this results from both nature and the handling by the various people along the supply chain. Consumers, standing in front of the cherry bin, can only estimate (at some cost) the distribution of cherry quality. For a given estimate, the consumer will decide a sampling rule, and when a cherry is discovered that is worth more than its price, it is selected. This process is called sorting.7 Consumers are not the only ones who can sort; sellers sort as well and can place the cherries in different bins or bags based on seller measurements. Once a seller sorts into different bins, a price is set, and buyers then sort through a given bin, if they want to. If the cherries in the bin are identical and known, the buyer does not sort and the quantity purchased is determined by the buyer’s demand for cherries of that quality. If there is enough variation in the quality of cherries, the buyer will start to sort and measure, and this results in a cost to the buyer that affects the net-price they are willing to give the seller. 5

6 7

In Chapter 9, we discuss rationing by waiting, and show that the waiting time that people spend in line to acquire a “free” good accrues to no one, implying that such a good lies in the public domain. For a more detailed discussion of sorting, see Barzel (1982). Because sorting is never complete, there is risk. Throughout much of this book we will ignore matters of risk aversion and always assume risk neutrality.

Information Costs

57

Thus, the quantity demanded for cherries increases as the demand for cherries rises, as the measurement cost falls, as the posted price of the commodity falls, as the average quality increases, and, most important, as the variance of the attributes distribution increases. With increased variance, there is no added penalty for inspecting an exceptionally poor cherry because it can be returned to the bin without penalty, whereas there is an added gain by finding an exceptionally good one. This variance, however, is a matter of choice for the seller since he first sorts to a given level. Suppose the cost of measuring the cherry attributes is the same for the buyer and seller. When the variability of the cherries in a given price bin is very low, buyers won’t be bothered to sort and will grab the cherries on the top of the heap. As variability increases, a point will be reached where sorting becomes worthwhile. The seller will sort the cherries just finely enough to this point so that buyers do not sort. In doing so, he minimizes the total amount of sorting and measurement costs. When the seller sorts each item is measured exactly once. On the other hand, when buyers sort (i.e., measure), the cherries are measured at least once; some will be measured twice or more. Thus the net price – that is, price net of the cost of measuring – at which the commodity can be offered is lowest when the seller performs the measurement, and competition across sellers will enforce this. This result does not depend on the level of the measurement cost, as long as this cost is the same for buyers and sellers. Whatever that cost is, the seller will always measure just finely enough to prevent buyers from measuring. Now, suppose the buyers’ cost of measuring is higher than the seller’s, perhaps because the seller has hired the lowest-cost sorters and has a comparative advantage due to some constraint on the consumer or because of economies of scale in employing sorting resources. Once again the seller wants to prevent buyer sorting and will now sort to a lower level, leading to a wider variance of cherry quality in a given bin. A striking counterintuitive feature of this result is that when the buyers’ cost of measuring is increased, the net price they pay for the commodity falls! Finally, suppose that the buyer has a lower cost of measuring. Even with a relatively simple product like cherries, this seems a likely case. Most commodities – even cherries – have numerous attributes whose levels vary across units, and these different attributes are valued differently across buyers. If a seller was to sort across all attributes, each unit might occupy a class by itself. If a commodity is not sorted so exhaustively, various buyers will find it worth their while to pick and choose by the attributes they value highly, but not ones by which the seller sorted the commodity. Whereas such sorting will generate a gain, it will be carried “too far” in comparison with the first-best level because the buyer obtains the valued attribute at zero marginal charge from the seller. The high seller measurement cost leads to the sellers inability to capture the entire value of his merchandise compared to the case where he knew its quality costlessly. On the other hand, when the buyers engage in sorting they

58

Part I Conceptual Issues

select items valued more than their price and capture part of the value. In later chapters we’ll address the fact that buyers compete with each other for this gain and in spending resources to capture, some of the value is dissipated. This dissipation, along with the costs of measuring, is also a transaction cost. The discussion of sorting has abstracted from other issues. Buyers have to decide on which store to purchase cherries from, and this depends on their estimates of the distribution of cherry quality across the stores – which requires measurement. While picking through the cherries buyers may eat or damage the fruit, and this may require monitoring to maintain the seller’s property rights – another transaction cost. These issues will be explored later, but for now the point is that the high cost of information results in transaction costs – costs that would not arise were the owner and the consumer of cherries the same person. If information about the cherries were costless, their initial owner would not have to relinquish any rights, and pilfering, damage, and excess choosing would be avoided. In reality, such public domain problems are unavoidable; people can take steps, however, to reduce the associated losses. One of the main tasks of this book is to articulate methods to reduce such losses. The Rights to Variable and Alterable Service Flows Property rights over an asset often include the right, or ability, to receive the income flow that the asset generates. When others, who are nonowners of the asset, can alter and redirect the income flow without bearing the full costs of that action, they lower the value of the asset. Since different distributions of property rights over the asset will constrain the uncompensated exploitation differently, we would expect that the distribution to emerge would be the one that maximized the net value of the asset, which is not constant and depends on the degree of variability and alterability of such assets. It is relatively easy to establish the rights to an asset’s income when the alterability and variability of its income flow are readily ascertained, because then it is easy to impose a charge commensurate with the level of income exploited or exchanged. When the income flow is known and constant (non-variable), it is easy to establish secured rights over the asset. If the flow is seasonal but fully predictable – for instance, if the income is from electricity produced by solar panels – then rights to it are easy to establish. Likewise, if the flow is not certain but is unalterable – for instance, if the amount of electricity produced only depended on the weather – then again the rights to it are easy to establish. The variability may reduce the value of the asset, but by not inducing transaction costs it does not affect ownership. When the exchange parties can alter a variable income flow from an asset, then transaction costs arise and establishing ownership over the flow becomes problematic. The presence of both variability and alterability means it is costly to determine whether the flow is what it should have been in any particular

Information Costs

59

case. Consequently, it is also costly to determine whether the exchange parties captured part of the income stream. Therefore, the exchange parties will engage in wealth-consuming capture activities, which include expense to prevent capture, because they expect to gain from them. In reality, randomness is pervasive and usually both exchange parties can alter the income flow generated by exchanged assets; ownership over the flow is therefore seldom if ever perfect. For instance, the income stream generated by a rented car depends, in part, on how smoothly the car operates. Since used and even new cars are not identical to one another, they are not expected to run equally smoothly. A smooth ride is an attribute that both the owner and the renter can affect. A renter will find it expensive to determine to what extent the smoothness of the ride of the rental car results from its character and to what extent it results from the care given to servicing it. It is expensive to determine the true mean and standard deviation of the population from which the car is obtained, and it is difficult to know to whom to attribute the actual performance. Similarly, the owner cannot tell how much the smoothness of the rented car’s ride has deteriorated because of the way it has been driven and how much it has deteriorated because of its character. As a result, the owner may gain by skimping on servicing rental cars – doing less than ownerdrivers would – and renters may gain by being less careful with rented cars – less then they would be with their own. Each party expects such behavior of the other. Therefore, the demand function for rented cars will adjust for the effects of inadequate servicing, and the supply function will adjust for the effects of careless driving. The net gain in using the rental market, then, is less than it would be were the two parties to exercise greater care. If smoothness were costlessly measurable, the effect that each transactor had on that attribute could be easily determined and accurately charged for. In reality, imposing such marginal charges accurately is prohibitively expensive, and maximizing owners will choose not to exercise their rights fully. Some of the income stream, then, is left in the public domain. It is partly recaptured by the exchanging parties, who act differently than owner-drivers would. Whereas rights are imperfect when both exchange parties are able to alter the outcome, for a given set of conditions only one distribution of ownership maximizes the net income from the asset, and thus its value to its original owner. As we have already stated, the general principle underlying the maximizing allocation of ownership is that the greater a party’s inclination to affect the mean income an asset can generate, the greater is the share of the residual (that is, ownership share) that party should assume. When the highest income the asset can generate requires exchange, some of the income potential will be used up in the process of affecting the exchange. The net income an asset will generate depends on the distribution of rights, which depends on the strength of those rights. A special case that facilitates the understanding of how ownership is assigned arises when only one of two exchange parties can affect the income

60

Part I Conceptual Issues

flow. Making that person bear full responsibility for his actions reduces transaction costs and leads to maximized income. If the other person were the owner, he would be subject to capture and the value of the asset would fall. To restate this, when information costs are present to create transaction costs, the Coase Theorem does not hold and the allocation of who holds the property rights matters for wealth creation. THE PRODUCTION OF INFORMATION

Information is valuable for two reasons. First it allows for the neoclassical gains that result from exchange and production. Without knowledge of the fundamental parameters of preferences, technology, and endowments, there could be no exchange and production. Second, as we’ve discussed in detail, specific information costs lead to transaction costs, and increases in certain types of information may reduce these costs. In understanding the economics of property rights, it is important to realize that the solution to the former problem often spills over to problems in the latter. Fredrick Hayek was an economic genius and worthy Nobel prize winner. In 1945 he published a wonderful article claiming that We must look at the price system as such a mechanism for communicating information if we want to understand its real function ... (1945, p. 526)

Hayek noted that an economy required a massive amount of information in order to allocate resources efficiently, and no individual human could possibly know or become aware of such information. The critical information is a matter of time and place – the idiosyncratic knowledge that specific people have at specific times regarding specific things. This type of knowledge is constantly changing, and not amenable to any statistical aggregation that would allow it to be uploaded to a central planner. Hayek argued that solving this information problem was the most critical part of achieving economic efficiency in resource allocation. Because this knowledge is held by individuals, decisions must also be made by individuals. But how can they do that? Each person is privy to their own set of specific and idiosyncratic knowledge, but this is hardly sufficient to make decisions on what to do. What to produce, where to do it, how to sell it, and so on, requires knowledge of all the other specialized circumstances to one extent or another. The ultimate solution, which according to Hayek humans stumbled upon, was the price system: prices produce sufficient information. The price system generates a price that acts as a sufficient statistic. That is, the price contains all of the relevant information necessary for a buyer or seller to make an appropriate decision. The firm owner need not know why a particular type of capital has become more costly, he only needs to know that the rental price has risen and it needs to be economized upon. Thus prices act to coordinate the actions

Information Costs

61

of millions of people with minimal effort in relaying the relevant information. The price system is, ... a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers ... in order to adjust their activities to changes of which they may never know more than is reflected in the price movement. (1945, p. 527)

As such, the price system is a stunning achievement in the production of information. An interesting passage in Hayek’s paper criticizes a common opinion of the time: It is a curious fact that this sort of knowledge should today be generally regarded with a kind of contempt, and that anyone who by such knowledge gains an advantage over somebody better equipped with theoretical or technical knowledge is thought to have acted almost disreputably. (1945, p. 522)

This sentiment is as common today as it was eighty years ago, and it seems unlikely that it is just the product of envy or a zero sum game view of the world. Prices allow for extreme levels of division of labor and the creation of employment that hinges on specialized knowledge. However, in a world characterized by complex commodities made up of numerous attributes that vary and can be altered, any specialized knowledge can also be put to nefarious use toward the capture of others’ property. Trading with an information specialist, whether a surgeon or a plumber is a risky business. On the one hand, the specialized information allows for significant gains from trade, but on the other it opens the door for capture activities. Wherever there is specialized information production then, we have asymmetry of information over the levels of attributes and the relative contributions of nature and people in the final production of the commodity. We would expect there to be concomitant distributions of property rights that lead toward a mitigation of the transaction costs that will naturally follow from this asymmetry. For example, consider the case of matchmakers. The term “matchmaker” comes from marriage markets, where specific specialized individuals (almost always older women) act to bring specific families together for the purpose of matching a young couple for marriage.8 But such intermediaries are not confined to matching single women and single men; they are present all over the place. Movie and book reviewers help match movies and books with viewers and readers; pet stores provide services that match the owners of particular types and breeds of pets with specific owners; apartment rental agencies match units with renters; sommeliers match wines with restaurant patrons; and employment agencies match firms and workers. And this just names a few. 8

See Barzel and Stephany (2018) on the relationship of information and intermediation.

62

Part I Conceptual Issues

Now, if information costs regarding the attributes of commodities prevents or lowers the gains from trade, then that information is valuable. A third party with a comparative advantage in producing it can facilitate the original transaction. Intermediaries, like matchmakers, are so prevalent because buyers are unaware of the full prospects of goods available in the market and may not even know how these prospects might satisfy their wants. Indeed, buyers, on their own, often cannot be aware of the prospects available in the market. A better informed expert can direct the buyer to a more highly valued good; moreover, the expert is often better informed about a buyer’s needs than is the buyer himself. Among many others, headhunters fall into the latter category. So do doctors, who can point to best treatments, Amazon connecting books to readers, and personal shoppers who provide helpful information that saves the client the effort of inspecting and evaluating numerous prospects.9 A matchmaker can also help in the production of a guarantee because the buyer cannot be sure of the quality characteristics such as longevity of the good in question. When desirable commodity characteristics are costly to produce and difficult to ascertain, a seller stands to gain by producing less of them. Buyers may protect themselves by inspecting the commodities they think of buying. But inspection is costly too, reducing the gains from exchange. The seller may guarantee his commodity, but then the buyer has to ascertain the seller’s credibility, which is costly as well. A buyer may distrust the seller enough to altogether prevent a trade from occurring (as with the “lemon” problem). An intermediary specializes in inspecting or evaluating, as well as in guaranteeing, may perform these functions at a lower cost than the buyers would. Moreover, the buyer may be able to discover the intermediary’s reputation more cheaply than that of the producer, inducing the intermediary to guarantee to the buyer the attributes of the good that are too costly to inspect. Two examples are those of the sale of a used car by a reputable dealer and an investment banker guaranteeing his estimate for the issuer of the IPO price. A dealer who has a reputation to maintain, and who can inspect used cars or a reputable investment banker who can estimate the IPO price for less than it would cost the buyer to do so, can facilitate the transaction by formally guaranteeing the car or the share price, and guarantee the non-contractible goods’ attributes by using reputation. Used car dealers are intermediaries who perform both matchmaking and guaranteeing functions. The (specialized) intermediary’s cost of evaluating the seller’s reputation is presumably low, and presumably he also makes it easy for the buyer to evaluate his own reputation. In addition, intermediation may save on the cost of evaluating reputation as it is subject to scale economies. An intermediary may discover the reputation of many producers, say apple orchardists, allowing each of numerous apple buyers to discover the reputation of just one seller, the one who brands the apple for retail sale rather than the reputations of each of the orchardists. 9

A good salesman is one who sells you what you value highly but didn’t know you wanted!

Information Costs

63

CONCLUSION

Information costs are critical in the creation of transaction costs and, therefore, critical for understanding why economic property rights matter for the allocation of resources and the creation of wealth. Information costs are necessary for transaction costs to exist. However, it is a particular type of information cost that matters, namely the costs that arise from separating out the effects of nature and people in determining the final quality of commodities. Quality is simply measured as the number of unpriced attributes relative to the priced attribute, and so to know quality is to know the level of a commodity’s attributes.10 The level of attributes is determined by both nature and human action, and this leads to the problem of being sold a low quality item at a high quality price. It also leads to problems of theft and other forms of appropriation. Efforts to mitigate these things are transaction costs. Thus transaction costs arise out of a particular type of information problem, namely who is responsible for the final level of commodity attributes. As noted, the very act of producing information through a price mechanism, necessarily leads to information asymmetries that require some type of transaction cost resolution. These resolutions can be thought of as distributions of property rights. In Chapter 5, we develop a general hypothesis about how such a distribution will be designed.

10

See Leffler (1982) for a discussion of this definition of quality and its implications.

5 The Theory of Economic Property Rights

INTRODUCTION

We began our discussion of property rights with Coase’s (1960) celebrated (and sometimes ridiculed) idea known as the “Coase Theorem,” which states that when transaction costs are zero, then economic property rights are perfect and resource allocation is efficient and independent of the pattern of ownership. In Chapter 1, we emphatically noted that this claim was not a statement about the real world. Had it been, much of economics, including this book, would have been superfluous. Rather, the Coase Theorem is a logical outcome of the neoclassical model – a model of an ideal world. The Coase Theorem highlights that this idealized model is necessarily incapable of explaining patterns of ownership. Furthermore, it implies that explaining the patterns of ownership rests on the concept of transaction costs. In Chapter 2, a terminology was developed to describe the pattern of ownership: A distribution of economic property rights for a particular commodity. Economic property rights have three dimensions: division, scope, and strength. Conceptually the distribution of property rights for a commondity is the set of all the (N) individual property rights over J attributes and R specific rights for that commodity. We represented this with a set of matrices: ⎛

b111 ⎜ . J ⎝ .. b1J1

R ... b1jr ...

⎞ b11R .. ⎟ . ⎠, b1JR

⎛

...

bn11 ⎜ . J ⎝ .. bnJ1

R ... bnjr ...

⎞ bn1R .. ⎟ . ⎠, bnJR

⎛

...

bN 11 ⎜ .. ⎝ J . bN J1

R ... bN jr ...

⎞ bN 1R .. ⎟ . ⎠ bN JR

Any element of a given matrix indicates the strength of a particular property right for a particular attribute for a given individual. The columns of a given matrix identify the strength of a specific type of property right over all of the commodity’s attributes for an individual. The rows of a matrix identify the 64

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strength of all the feasible property rights over a single attribute owned by an individual. In principle, this distribution can describe the economic rights that result from any type of exchange, organization, or institution; the complexity in terms of goods, attributes, and rights involved is practically endless. The distribution of property rights must be established and maintained at some cost, and these costs are transaction costs. These transaction costs fall on various people, some of whom may not even be owners of the commodity. Transaction costs are the other side of the property rights coin. It makes little sense to speak of these concepts independently, and neither does it make sense to speak of them as being identical. Rather, there is a functional relationship between the two. Because transaction costs are positive any specific property right is likely imperfect.1 Furthermore, there is a mapping of property right strength to joint wealth. Holding all else constant, an increase in the strength of a property right increases joint wealth because owners are more likely to make wealth enhancing decisions when they bear more of the benefits and costs of those decisions. Stronger property rights can come from many different sources. For a given set of owners, there may be an exogenous (to them) increase in legal right or moral rights over their asset; an exogenous (to them) increase in state enforcement of their claims; or an exogenous (to them) increase in the ability to use some new technology to maintain their economic property rights. On the other hand, a given set of owners may endogenously decide to rearrange ownership over attributes and rights. Specialists in owning particular attributes or in holding specific rights might be able to protect them better, or might be much more productive in using them.2 Thus, an increase in divided and incomplete ownership can be a second mechanism by which property rights operate in wealth creation. Finally, in Chapter 4, we argued that information costs were a necessary condition for transaction costs. All transaction costs are fundamentally a consequence of information costs, but the reverse is not true. Information costs, on their own, lead to simple uncertainty. Uncertainty, just on its own, can be dealt with through contracts and be eliminated when contracting is costless. In addition to information costs, some other condition has to be present that prevents people from determining, either immediately or over time, the cause of final commodity quality. When such a cause becomes ultimately known at a low cost, then some type of contract can be arranged that assigns prices in a way to induce an outcome closer to the neoclassical first-best outcome and the distribution of property rights is of less consequence. We argued that recognizing the variable and alterable character of commodity attributes was a sufficient and useful way of thinking about what kind of information costs 1 2

In Chapter 3, we noted some exceptions to this claim, but they tend to be contrived and unrealistic. As we noted in the last chapter, specialists also have private information that might allow the exploitation of others, that is, lower the strength of some economic property rights.

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generate transaction costs. The more variable and alterable a commodity is, the greater is the role of transaction costs and the more important the distribution of property rights becomes. In this last chapter of Part I, we conclude the discussion of property right basics by developing a theory of property rights. This theory is articulated at a general level and provides an overall framework for thinking about how economic life is organized. In the subsequent parts of the book we examine specific applications of this theory to see how it can work in practice. THE PROPERTY RIGHTS HYPOTHESIS

The role of an individual in our discussion of property rights has been implicit. Like most economics, however, the economic analysis of property rights rests on methodological individualism. All economic decisions ultimately rest with individuals; they are not made by organizations and institutions. Likewise, individuals always interact with other individuals, regardless of whether one or all interacting parties represent organizations in some capacity. Individual’s objectives are relatively clear, whereas organizations as such do not have objectives. Thus, we can apply economic reasoning to property rights held by individuals. Expressing the exchange of goods as an exchange of rights between individuals is not part of common parlance. For example, the payments supermarket shoppers make for merchandise is often viewed as exchanges between individuals and an organization – between customers and the store. However, this view is a shorthand that conceals the actual series of property right relationships between individuals. It hides what rights each person receives and concedes in the exchange. Consider the relationship between a cashier and the customer on the one hand and between the cashier and the store owner on the other. A cashier in a store has the right to collect money from the customer who buys merchandise in the store. The cashier, of course, does not usually retain the customer’s payments; rather, in exchange for an hourly wage, the cashier cedes to the store owner the rights over this time as well as rights over the cash received from the customer. In practice the cashier might shirk in the ceding of time – i.e., deliver less than what was agreed upon – and might occasionally shortchange the customer and keep that change, as well as once in a while steal some or all of the cash received. The flow of goods and payments, however, is always between individuals. The assumption of individual maximization and in particular the assumption that individuals maximize the value of their economic rights is useful not only directly in the analysis of individuals’ behavior but also indirectly in terms of what underlies the functioning of organizations – indeed, of all societies. Individual maximization implies that whenever individuals perceive that certain actions will enhance the net value of their rights, they will undertake such

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actions. These actions might include enforcement and protection, destruction or donation, or a limitation on the scope of their property rights. These actions also, importantly, include working with others to devise rules and constraints on behavior and things. This always applies, whether the individuals operate in markets, firms, families, tribes, government, communist societies, or any other organization or institution. Within any given context, some individual also chooses, alone or in cooperation with others, the distribution of property rights that are actually those in effect. Each individual is interested in their own net wealth, but this also depends on the actions of others who are also interested in their wealth levels. We claim that the ultimate distribution of property property rights is the one that maximizes the net joint wealth of the decision maker(s). That is, our theory of property rights is: Property Rights Hypothesis: The equilibrium distributions of property rights maximize the joint wealth net of transaction costs of the individuals involved.

This is a powerful hypothesis, and it highlights the fact that changes in the distribution of property rights can instigate the creation of wealth via two different channels. First, wealth is created through the standard neoclassical channels of exchange and production; however, these channels depend on a given distribution of property rights. Specific property rights determine behavior that leads to specific levels of wealth through production and exchange. For example, if a particular social welfare scheme pays people not to work, naturally there will be fewer individuals working and a concomitant fall in measured output. Generally speaking and transaction costs constant, we would expect that individuals will choose the distributions of property rights that encourage the (neoclassical) creation of wealth. Second, net wealth is directly created through the reduction of transaction costs. Every distribution of property rights leads to behavior that creates transaction costs. In the cashier example above, the cashier who is paid a wage has a set of incentives to shirk, sometimes not give the full change and perhaps steal from the till. To reduce such behavior, the cashier’s employer will supervise the cashier. If a manager does the supervision, then the manager has relationships with the store owner and also requires monitoring. When supervision reduces the losses from shirking and theft by more than the costs of the supervision, then net wealth increases. In other words, reducing transaction costs, even if there is no increase in gross wealth creation, is a net wealth creating activity. A dramatic example of the dual source of wealth creation and the importance of transaction costs comes from the British Navy’s use of the weather gage during the age of fighting sail (c. 1500–1840).3 During naval battles in this period, square rigged sailing warships would line up against the enemy and blast away at each other until (usually) one side was victorious. The weather 3

See Allen (2012), for more details on transaction costs and the role of the weather gage.

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Part I Conceptual Issues

gage meant that your ship was upwind of the enemy. To be downwind of the enemy was to have the leeward position. The leeward position was a superior position on every technical (neoclassical) margin. Being downwind meant that the ship was heeled over by the wind away from the enemy ship, and this allowed all rows of cannon ports to be opened at once for a full broadside blast. Because the ship was heeled over, the cannon could fire farther, which meant that the leeward ship could open fire before the enemy. Finally, if fatally damaged, a leeward ship could quietly drift behind their line to relative safety. To have the weather gage was to lose all of these technical advantages. Amazingly, the British Navy insisted, to the point of death by a firing squad, that their captains take the weather gage position – and they ruled the waves for a period of two hundred years doing so. As it turned out, the loss of technical advantage was dwarfed by the reductions in transaction costs that the weather gage brought about; the weather gage drastically reduced the problem of monitoring captains in fulfilling their duty to engage enemy ships. Captains often died in ship battles and had little incentive to actually engage the enemy. By forcing their captains to take the weather gage, the Navy forced the captain to engage because the square rigged ship would eventually drift into the enemy line and its fire. Being forced to fight forced the captain to train his crew in firing rapidly and boarding the enemy ship as quickly as possible. Thus, although the British Navy often had a hard time catching enemy fleets, when they did they were almost unbeatable. Solving the transaction cost problem turned out to be more important, in this case, than solving the matter of maximizing cannon fire. Returning back to the property rights hypothesis, it notably shows that the goal of the individuals choosing the distribution of property rights is not to minimize transaction costs. There is an analog to this in the neoclassical theory of the firm. The neoclassical firm’s objective is to maximize profits, not minimize costs per se. That is, conditional on choosing the profit maximizing level of output, the firm minimizes costs, but cost minimization by itself does not imply profit maximization. Likewise, maximizing wealth net of transaction costs means that transaction costs are minimized for that level of wealth, but not that transaction costs are minimized. Indeed, the optimal distribution of property rights might involve substantial transaction costs; likewise, the distribution of property rights that leads to minimal transaction costs might also lead to minimal production. A momentary return to Coase (1960) shows that he was already thinking along the lines of the property rights hypothesis. After he examined the zero transaction cost case of various property right entitlements, he considered what happens when such costs do exist. The first thing he observed was that the optimal outcome is not independent of the initial distribution of rights. When market prices do not actually work for free, it does not follow that market exchanges always lead to the optimal outcome. Rather, some alternative could do better. He wrote:

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It is clear that an alternative form of economic organization which could achieve the same result at less cost than would be incurred by using the market would enable the value of production to be raised. As I explained many years ago, the firm represents such an alternative... (1960, p. 16)

A “firm” constitutes a distribution of economic property rights, usually a complex one.4 Within the firm there are many assets, each with their own collection of attributes. There are usually multiple people, each with their own legal rights to various assets and flows within the firm, and each being compensated in a way that spells out their ownership claims over the assets of the firm. These factors determine the total transaction costs associated with the firm. Indeed, the very nature of the firm should be thought of in terms of the distribution of property rights. Partnerships, sole proprietorships, corporations, and employee-owned firms are defined in terms of their property rights structure. Coase merely pointed out what became obvious decades later: If markets do not work freely, then it is possible that the net wealth created by the firm could be greater than a market. Coase went on: It does not, of course, follow that the administrative costs of organizing a transaction through a firm are inevitably less than the costs of the market transactions which are superseded.5 ... But the firm is not the only possible answer to this problem. (1960, pp. 16–17)

If operating within the firm is costly, it might be more costly than a market exchange for allocating rights properly. Furthermore, there may be still other alternatives that provide a better distribution of rights. Coase then went on to write something quite remarkable: An alternative solution is direct government regulation. (1960, p. 17)

Coase, who personally may have had libertarian leanings, provided a rationale for state regulation! And why not? Even if the cost of state provision is higher that that of private provision, it might well be the case that the state can lower transaction costs in some situation by so much that net wealth increases. The last solution that Coase considered was the status quo. There is, of course, a further alternative, which is to do nothing about the problem at all. (1960, p. 18)

Which led Coase to his big conclusion: ... the problem is one of choosing the appropriate social arrangement for dealing with the harmful effect. (1960, p. 18) 4 5

We discuss the nature and meaning of a firm in Chapter 7. Notice Coase’s use of the term “administrative costs” when it comes to the firm. Coase never actually used the term “transaction costs” in his 1960 paper. Rather he claimed there were “costs of transacting” in markets and “administrative costs” within firms. Later, in his collected works (1988), he would state that both of these fall under the umbrella of transaction costs.

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What is the “appropriate social arrangement”? Within the context of the theory of economic property rights, we can interpret Coase as saying that it is the distribution of economic property rights that maximizes wealth within the context of the harmful effect, net of the transaction costs associated with that distribution. Coase considered four cases: markets, firms, the state, and the public domain. He then analyzed several court cases and argued that judges are guided by this hypothesis. Life is more nuanced than the four arrangements Coase considered. There are almost countless forms of markets, firms, states of public domain, and government interventions. Within any given type, there is variation in the degree of ownership over any given attribute. There are also far more complicated property right situations than judges deciding on a specific legal rule in a particular context. The property rights hypothesis does not explicitly state how the net wealth maximizing distribution of property rights arises. On the one hand, and especially for small and easily measured types of production and exchange, it is reasonable to imagine ownership structures that are designed by those involved. Those people involved in contracts, private exchanges, firms, and the like can reasonably be assumed to have designed the property right structures that they ultimately operate in. On the other hand, there is no reason why distributions of property rights cannot evolve. This evolution can take place gradually, by accident, or by trial and error as various individuals try out particular distributions for themselves. They might also take place through conquest and forced replacement, or through spontaneous orders.6 Distributions that generate higher levels of net wealth have a survival characteristic and are more likely to be adopted in competitive environments.7 Distributions that generate more wealth allow their jurisdictions to become more powerful relative to their neighbors, both through direct production and through attracting more people who seek the better wealth opportunities. Thus these distributions are more likely to survive compared to distributions that generate low levels of net wealth.

“EFFICIENT”

PROPERTY RIGHTS

The theory of economic property rights claims that the equilibrium distribution maximizes joint wealth net of transaction costs, which implies that the distribution is “efficient,” in some sense of that word. On the surface, this 6

7

The idea of these orders go back to Adam Smith and were developed by Hayek. A spontaneous order (like markets and language) arise out of human actions and not design. It is conceivable that this could also apply to economic property rights, especially in terms of initial conceptions property or how natural rights might influence rights. This idea was first articulated by Alchian (1950).

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sounds like a naive approach to the study of rights, but such an impression results from a limited notion of the role of transaction costs.8 Property rights are held by individuals. Each individual is a maximizer and prefers distributions that increase their net wealth. When a given distribution of property rights maximizes the joint net wealth level but does not maximize a given individual’s wealth, there will be tension, disagreement, and opposition over the distribution. To put this another way, every distribution of rights leads to a particular distribution of income. That distribution of income must be maintained at some cost. As the number of individuals involved and the complexity of the context increases, the number of divergent interests increases, further increasing the complexity and degree of opposition, and increasing the costs of maintaining the distribution of income that does not reflect these interests. The opposition can, of course, take many forms including lobbying, political opposition, non-cooperation, sabotage, and violence. The nature of this opposition and the ability of others to deal with it – either privately or through some type of institution – determine, in part, the transaction costs of that distribution. It seems likely that no distribution of property rights is ever a Pareto improvement on others, and opposition will always exist. The resulting transaction costs of any distribution, therefore, is a major force on what distribution of property rights ultimately survives. This means that the equilibrium distribution of property rights and concomitant resource allocation that we observe might be vastly different from a first-best zero transaction cost allocation. Such a second-best distribution is “constrained efficient,” and this is the sense of efficiency we use. Such a constrained efficient distribution might involve a strong dictator extracting rents from a population with low average incomes. Our interpretation would be that within the circumstances faced by those involved, this was the best that could be achieved. That is, the transaction costs of a “better” distribution of rights (i.e., one that generated a higher gross level of wealth) are too high to increase net wealth.9 For example, suppose a particular skewed distribution of property rights had a strong degree of private property held by a few. These strong private property rights will provide powerful incentives to produce for those who possess them, but for the many others lacking property rights, the work incentives are weak. The result will be a wide and skewed distribution of income. In such

8 9

Eggertsson (1990, pp. 249–262) calls this hypothesis naive if it does not consider the “social and political institutions” involved. We would agree with this sentiment. This is not a Panglossian view. It is not that we live in a world with the best of all possible property right distributions. In some situations, the distribution of property rights in existence might lead to terrible outcomes but are still not worth changing because such change would generate too high transaction costs (such as those associated with individuals’ rebellion against a brutal dictator).

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a situation, the massive number of losers might collectively reject the distribution and violently rebel. The violence on the part of the poor masses is an attempt to establish economic property rights over the wealth legally held by the few. Those with wealth will engage in some form of protection to maintain their property rights, including the use of violence. Together, the threat of violence and the ability to protect will lead to a new constrained efficient allocation. The ultimate distribution of property rights might be very similar to the original distribution because the wealthy few were able to defend their concentrated wealth. Or it might lead to some form of voluntary redistribution on the part of the wealthy that preempts violence and revolution. In this latter case, the new distribution of property rights would lower the threat of violence (or theft) sufficiently to compensate for the reduction in wealth to the few through redistribution, making net wealth higher. In both cases, the distribution of property rights observed is constrained efficient given the transaction cost constraints. Whether evolved or designed the distribution of property rights observed maximized joint wealth under the specific circumstances faced by those involved. In this sense, the observed property rights are constrained efficient. We are neither claiming that the observed distribution of property rights is first-best efficient nor that it is fixed in stone, has some sort of moral authority, or that is designed by an all-knowing social planner. The equilibrium property right distribution is not a global utopia, and in a given situation, the optimal property rights might still lead to a low wealth outcome.10 We will examine several mechanisms by which property rights are established and maintained. These mechanisms will mostly be ones of design, but all distributions must be regulated by a Darwinian force. Individuals or groups of individuals may choose a distribution, but if it fails to produce wealth compared to some other distribution, it will likely fail, either through internal competitive forces or external take overs and wars.11 Alternatively, when a given distribution is successful within the context of a particular time and place, it will tend to outperform other distributions made by others attempting to achieve the same goal. Eventually, within that society, the better distribution begins to dominate, take over, and be copied. Long lasting distributions of property rights, therefore, have a Darwinian survival logic. The idea of an “efficient” economic property rights seems too easy to criticize, but only because the critic has failed to appreciate the notion of

10

11

Low when compared to the first-best outcome. When an optimal property rights distribution leads to low wealth levels relative to other jurisdictions, we might expect it to be fragile and not long lasting. Such a situation will create incentives for innovation to reduce the transaction cost constraint or incentives for others to invade and force a new distribution. This is subject to the transaction cost caveats just mentioned. In addition, the length of time to failure may be quite long.

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constrained efficiency.12 No organization is perfect, and we can always imagine a better world. Property rights are constrained efficient in that they not only out-survived their competitors, but when they failed to achieve some other better feasible outcome, the affected individuals found them not worth changing. Something was in the way. There may yet be better ways of organizing life that have not been discovered, but this misses the point. When we look at any distribution of property rights that have lasted a long time, we are drawn to the Darwinian conclusion that these rules and conventions have survivability characteristics. Had a superior feasible outcome been affordable, it would have arisen instead of what we observe. Such an approach does not mean that property rights cannot change. Many of the property right distributions of the past are extinct or exist today in name only. How could this have happened if they were constrained efficient? The answer is that the environment they existed in changed in such a way that they could no longer compete against new, more efficient distributions of property rights. OPERATIONAL FEATURES OF THE PROPERTY RIGHTS MODEL

It follows from the theory of property rights that the value of a commodity or asset will depend on the flow of utility or income the good generates to its owners, net of the transaction costs involved. If the good is being exchanged, then the value in exchange is a function of the utility or income generated net of the transaction costs of the exchange. At this stage, we can state some general characteristics of efficient distributions of property rights. First, consider the division of ownership over attributes. Other things equal, as the ability of a person to affect their income flow from an asset increases, their ownership of the asset should increase. As noted several times, attributes tend to be alterable by people, but not all people have the ability in terms of access or talent to alter attributes. When the individual most able to alter the attributes is the owner, they are more likely to alter them in a way that enhances net wealth. A nonowner who can alter an attribute will do so in a way that transfers wealth from the original owner through some type of capture. This forces the original owner to engage in transaction cost behavior to protect their attributes, or perhaps forces them to forgo interacting with others all together. Therefore, other things equal, those with a low cost to alter the attributes are likely to become the attribute owners in order to align their private interests with the net value of the asset. Second, consider the scope or completeness of property rights. As mentioned, individuals who have access to a commodities attributes, but are not 12

To be fair to the critics, economists often make a normative declaration regarding certain institutions or property rights as “efficient” and therefore “good” or “better.” See Congost et al. (2016) for a critique of economic talk of “good and efficient” property rights.

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owners of those attributes, will exploit them to their own advantage and lower the value of the commodity. One method to mitigate this is to restrict the types of decisions those with access are allowed to make. If someone with access can use the attribute but not sell it, the ability to overuse might be sufficiently curtailed. The maximization of the net value of an asset, then, involves types of rights granted to individuals in order to most effectively constrain uncompensated exploitation of the attributes. One type of right is control over the income flow an asset generates. The value of an asset is lowered when nonowners are able to alter its income flow without bearing the full costs of their actions. When the highest income flow requires exchange, the net income it generates will depend on the scope of property rights across the individuals involved in the exchange because this determines the ability of each individual to direct income toward their own benefit. The greater the ability of an individual to alter the income flow, the more likely that individual will possess the property right over the flow. For example, if only one of two exchange parties can alter the income flow, then making that person own all property rights and bear full responsibility for their actions leads to the income being maximized. In this case, a specific scope of rights (all held by one person) maximized income under a particular circumstance.13 There is only one distribution of property rights that maximizes the net income from an asset, and thus its value to its owners. This distribution depends on the gross income stream the asset generates, the value of the contributions of different individuals, and the costs of policing and measuring the attributes of the asset. Since these and similar magnitudes are measurable, we have the ingredients necessary for an operational theory of property rights. These operational features also apply to the analysis of constraints. Because transaction costs are positive, opportunities arise for some people to capture the wealth of others. These opportunities arise, in part, from people’s ability to overuse and to under provide unpriced attributes when exchanging with each other. Exchange partners may allocate specific types of rights to each other in order to reduce the level of this undesired behavior. Consequently, property rights – particularly the right to consume what appears to be one’s own property – are often restricted or limited in scope. For example, in the context of leased land for grain farming, farmers with access to the valuable soil nutrients can over use them to increase the current crop at the expense of the landowner who has a difficult time monitoring such behavior. In response to this, however, the land owner may insist (and the farmer accept) a particular type of contract that constrains this behavior on the part of the farmer. In Chapter 6, we’ll see that cropshare contracts, in which a farmer pays a landowner a share of the crop as payment for renting 13

In other words, with positive transaction costs the Coase Theorem cannot be invoked. A different scope of rights would not have maximized income.

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the land, is one such restriction that increases the net value of the exchange by implicitly policing the exploitation of the soil. Because the character and incidence of the constraints are often predictable, the analysis of constraints can be incorporated into the study of property rights. THE

“PROPERTY

RIGHTS ” LITERATURE

An enormous amount of literature written in the last half century departs from the neoclassical, costless transacting, model. This literature, in which the costs of information play a major role, is diverse, and thus far no single model has stood out as the most useful one. Different approaches with a bewildering array of names proliferate: “Agency theory” or the “principal-agent model,” “market signaling,” “rent seeking,” “bounded rationality,” “asymmetric information,” “organization theory,” and “contract theory.” It is difficult to determine the precise differences between and even within these approaches because, as a rule, many assumptions are only implicit. Often differences are simply matters of nomenclature. Particular literatures simply emphasize specific types of transaction cost behaviors. For example, in labor or law and economics, it is common to see terms like “shirking,” “moral hazard,” or “adverse selection.” All three are specific types of transaction cost problems. Shirking is generally the practice of a worker not providing the labor service expected by an employer in exchange for a given wage. Moral hazard is ultimately the act of one party over using an attribute legally owned by another because the attribute is either priced inappropriately or not priced at all. In both cases they are a type of “theft” and therefore are a transaction cost. Adverse selection is the problem of having a biased and costly group show up, and it results because the cost of measuring the type of person is prohibitive. Once again, the measurement cost is a particular type of transaction cost. There are other cases where literatures tend to focus on particular type of transaction costs, per se. In these cases, phrases like measurement, enforcement, bonding, rushing, monitoring, policing, and the like are center stage. In all cases like this, the literatures are dealing with matters of establishing and maintaining property rights, and therefore these are all specific examples of transaction costs and property rights topics. There is another large transaction cost literature based on the writings of Oliver Williamson; indeed, the phrase “transaction cost economics” is most often associated with him. Williamson’s work is another case with a focus on specific types of transaction cost problems. For example, his concept of “asset specificity” deals with assets that involve sunk investments that generate quasi-rents that can be captured through bargaining that takes place after the specific investment has been made. Since the attempt to capture wealth is just one particular method by which a property right is established over the quasi-rent, the problem of asset specificity is a straight forward property rights issue. The different language used by Williamson, and his constant reference to

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opportunism, simply makes it look like a different type of problem.14 Indeed, an early and popular paper by Klein, Crawford, and Alchian (1978) probably did more to advance the issue of quasi-rent appropriation, but this was done entirely in the context of economic property rights. The property rights approach that we are articulating contains more than just a specific relationship to transaction costs. In particular we emphasize the fact that reducing transaction costs is a wealth enhancing activity in its own right. This feature distinguishes it from “public choice” and the idea of “rentseeking.” Rent seeking is a transaction cost behavior, and indeed, the problem of asset specificity is just a specific example. More generally, rent seeking is the practice of privatizing wealth that is in the public domain. Since such activities are costly, the costs of rent seeking are transaction costs. However, those who engage in the rent seeking literature, whether applied to market or government activity, tend to ignore (almost to a fault) the gains from reducing rent seeking. This literature concentrates on people’s efforts to capture wealth from each other and neglects the opportunities to gain through avoiding waste. Indeed, it neglects the possibility that, individually and collectively, people gain by taking advantage of the opportunities available to avoid waste. Thus they miss the fact that particular types of organizations (distributions of property rights) are designed to mitigate a rent seeking problem.15 Our property rights approach also stresses that goods are complex with multiple attributes, divided ownership, and incomplete and imperfect rights. Some literatures with a transaction cost element eliminate some of these features and drift away to significant degrees. For example, the starting point of traditional “agency theory” is that a principal’s attempt to maximize profits are frustrated by agents whose objectives do not coincide with the principal’s. In such models, there is a strong assumed asymmetry between the two parties, in that the agent is able to costlessly engage in shirking, but the principal is not – at any cost. Various types of monitoring are also either prohibitively costly or free. The result is a relatively simple model where the agent chooses an effort level and the principal chooses the contract form and terms. Because there is often only one margin for transaction cost behavior (usually effort on the part of the agent), there is no transaction cost trade-off to explain why the relationship is organized one way over another. In this literature, the lack of a trade-off led to the introduction of risk aversion on the part of the agent to resolve the problem.16 The models in agency theory, therefore, have a root transaction 14 15

16

The term “opportunism” is just a descriptive way of saying that individuals maximize, but with a pejorative and ambiguous connotation. It adds nothing to a theory of property rights. A similar problem is found in much of the “signaling” literature. A signal is a costly investment to indicate a type – an effort to strengthen the right to some stream of earnings or commodity. However, in this literature there is often an emphasis on the signaling costs, and not a recognition that it is the solution to some transaction cost problem. Stiglitz (1974) is often credited with first articulating the principle-agent model, but credit should go to Steven Cheung (1969) who first came up with it. Cheung (1983, p. 2) later regretted the innovation.

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cost problem, but the very specific model assumptions diverts attention from the reciprocity of most principal agent relationships and gives the model little empirical content due to the introduction of unobservable risk preferences. Likewise, in the 1980s, a series of papers written by Oliver Hart and coauthors created a new “property rights” literature that was based on a narrow set of questions regarding firms and which considered narrow views of property rights.17 Ownership in this literature was defined in terms of legal rights, and property right strength in terms of control was either zero or one. That is, legal rights were perfectly enforced. A fundamental (and sound) point in this “property rights” literature was that rights are held to maximize value, and that is prohibitively costly to contract for all future uses of an asset. However, in a classic example of trading off too much content for tractability, two additional unsound assumptions were made: owners costlessly contract over “contractible uses” of their asset; and owners maintain full control over the “residual” uses not covered by contract. These assumptions lead to the equivalence of economic and legal owners protected by a free state. As pointed out in Allen and Barzel (2016), the extreme assumptions prevent any useful analysis of real world organization because they depart too much from reality.18 Our property rights approach, with its focus on maximizing joint wealth net of transaction costs, emphasizes looking at the entire picture. Whether considering simple contracts between two individuals or the role of the state in assigning legal ownership, the focus of the theory is on how the distribution of property rights can influence production and resolve transaction cost problems. To the extent that the distribution of wealth matters, it matters through those two channels. This approach builds on a long history that goes back at least to Knight (1924) who pointed out the significance of recognizing the economic role of property rights on the ultimate allocation of resources. The list of people who have brought operational elements to the analysis of property rights is too long, but a constant inquiry as to “who owns what?” and what, precisely, each party receives and concedes in a transaction have helped to keep the property rights approach in touch with reality. These simple points are nevertheless worth mentioning because they are frequently overlooked. The relative ease of rendering the property rights model operational are made clear in the following chapters.

17

18

The two classic references to this literature are Grossman and Hart (1986) and Hart and Moore (1990). See also Hart (1995). Foss and Foss (2015) and Allen and Barzel (2016) each provide critiques of this approach. Foss and Foss (2015, p. 394) claim that this literature comes close to a “Kuhnian loss of content,” in that it was truly a step backwards.

P A R T II

CONTRACTS, ORGANIZATIONS, AND INSTITUTIONS

Transaction costs arise because human beings attempt to gain at the expense of others, while at the same time avoid being taken advantage of. Transaction costs are a byproduct of human interaction. People interact in many ways, and certainly exchange and production are common forms of interaction. Exchange involves a transfers of rights between people. Since these rights are imperfect, there is an opportunity for those involved to capture more than what was agreed to. This threat can be mitigated by placing various restrictions on the rights being transferred and by dividing ownership over attributes. In this way, most exchanges are more than caveat emptor interactions. When these alterations to the distribution of property rights are relatively simple, they manifest in the various types of contracts that are common in our experience, like a rental contract. As the alterations increase, cooperation may require some form of direction beyond that provided by prices and simple contract terms. At some point, this direction becomes detailed and complicated enough that it begins to resemble what we colloquially consider to be a firm. There is, then, a spectrum of organization restrictions between a pure exchange and a firm, as opposed to the standard assumption of a dichotomy. In many instances, human interactions may best be regulated through a bundle of legal, natural, and social rights. From the perspective of individuals, these regulation systems are exogenous, and we consider them as institutions. Importantly, institutions exist and are important because the influence the economic property rights of individuals. Institutions, however, are also distributions of property rights allocated to the members involved. As such, institutions are endogenous within the economic system and therefore are also subject to an economic analysis.

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INTRODUCTION

Exchange is at the heart of economics. Whether during the various stages of production or through the final act of consumption, exchange always takes place between the owners of labor, capital, other inputs, and final consumers. In the neoclassical model, exchange is considered a transfer of goods between people because all goods are simple and perfectly owned. However, an exchange is actually an agreement to imperfectly transfer (or reallocate) property rights among the various parties, and so an understanding of exchange and how it is organized in the real world requires an understanding of the economics of property rights.1 An exchange can be formal, written, and enforced by the state; they can also be informal, oral, and unenforced in practice by law. When an exchange is supported by the state, it often has the status of a legal contract, although in common language we often call state unenforced exchanges contracts as well. Thus the legal property rights around contracts are an important component of the transfer of economic property rights. When exchanges are unenforced by the state, then they must be self-enforced by the parties through various means, including reputation. When goods are complex, some parts of the exchange might be enforced by the state, while other parts are self-enforced by individuals. We begin with a general discussion of private contracts that are enforced by the state. The incentive to exchange through contracts arises from the gains from specialization, but effort to capture these gains opens the door to transaction costs when the commodity being exchanged has variable and alterable attributes. In an attempt to mitigate these transaction costs, contracts often 1

Some in the New Institutional Economics field treat contracts as part of a “golden triangle” along with property rights and transaction costs. This is incorrect. Contracts are not a fundamental concept but rather a name given to a specific transfer of rights through exchange.

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divide ownership across attributes and restrict the type of economic property rights participants hold in order to improve the strength of rights for the appropriate individuals. These voluntary divisions and restrictions define the various types of contracts we observe and lead to a theory of contract choice.2 After a discussion of the general contracting problem, we examine the case of land contracts in farming. Farming is still one area where a single person or family undertakes the bulk of production activities. Within the context of a simple family farm, the various contracts that they engage in are also relatively simple. Examining such contracts isolates some basic contracting problems that can be obscured in more complex organizations. Finally, we consider the role of contract law as a means of mitigating transaction costs of contracting.

COLLABORATION BETWEEN INPUT OWNERS IN EXCHANGE

Imagine a process of production that involves bringing together multiple types of inputs: labor, land, capital, and so on. In the typical textbook treatment, a production function is introduced, and this function yields the marginal products of each particular input. All inputs are assumed to be uniform and all relevant information about them is freely available. Given the productivity, market prices of inputs, and product prices, the optimum quantities and values of each input are easily determined. In such a setting, the problem of organizing production is irrelevant (Coase Theorem) and not addressed. The textbook assumptions, however, are a poor match to reality. Real production requires owners of specialized inputs to cooperate under conditions where random acts of nature affect output. In agriculture, weather, pests, and other forces affect output differently during different periods and at different locations. In addition, each input is nonuniform. No two pieces of land are identical, nor are any two workers, and determining the properties of each input requires costly measurement.3 Together the random factors and nonuniform specimens mean that the actual contributions of individual inputs are difficult to determine. Therefore, compensating input owners according to the average productiveness of workers in their class is not satisfactory because 2

3

Throughout the chapter (and book) we assume parties are risk-neutral, and the Coase Theorem provides a logical justification for this assumption. The Coase Theorem is violated only because transaction costs are positive. This means that transaction costs are a sufficient grounds to explain any distribution of property rights like a contract, and there is no need to invoke risk aversion. It may seem, however, that within a given contractual problem between individuals that the role of risk aversion is obvious and important. This impression stems from the simplistic view of goods. When many sources of variability confront the parties, the effect of specific contracts on overall riskiness becomes less clear and less important. Differences in land include incidence of rocks and ponds, steepness and variability of terrain, area of arable land, type of soil and degree of soil erosion, access to groundwater, presence of various nutrients, level of moisture, location and elevation, exposure to wind and sun, quality and quantity of irrigation canals, availability of pumping equipment, types of roads and rail nearby, and distance to markets. Differences in humans is even greater.

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individuals can mask their own low-level contributions by attributing them to other forces. Difficulties in determining actual contributions create opportunities to capture some of the gains from cooperation at the expense of the other parties to the exchange. Such attempts to establish ownership through capture make cooperation among individuals costly. Individuals, however, will organize their transactions to maximize the value of their output net of conventional input costs as well as the transaction costs that arise from the wealth capture. Individuals can gain by organizing their transactions in such a way as to lower these costs. Let us consider this with a stylized example. Suppose that some production process involved labor and the use of a particular machine. Given the total labor effort in production, there is some optimal number of machine hours that maximizes the total value of output. Only a fraction of workers, however, own the machine; other nonworkers may own the machine but not the human capital to operate it. Those who own machinery can gain by cooperating with those who lack them. In order to realize the gains, the input owners must organize an exchange with each other. We consider three methods by which the two owners can collaborate and in which ownership patterns are preserved: (1) the wage contract, (2) the rental contract, and (3) the share contract. Before analyzing the general case in which the quality of both the labor and the machine is variable, consider the special cases in which either the machine or the labor is uniform. Suppose first that machines are entirely uniform and unchangeable. Further suppose that the machine owner hires the worker by a wage contract. When the worker is paid by units of time, he gains from shirking, exerting himself less per hour than he would if self-employed. Because output is subject to variability, it is difficult to differentiate the effect of shirking from random factors that also reduce output. Therefore, under these conditions, the wage worker requires supervision. Since supervision is costly, economy in its use will be exercised and the supervision is never perfect. As a result, the worker takes advantage of the opportunity to shirk and does not work as hard as if self-employed. As attractive as shirking may seem to the wage worker, he loses as a result of it because wage payments will be adjusted to the expected reduction in effort. The worker is paid, on average, for what is accomplished. When average productivity falls due to shirking, wages are lower. If the worker was perfectly monitored, he would work harder, be paid more, and be better off because the marginal cost of effort is less than the increased marginal value of output brought about by that effort. This is why the wage contract was entered to begin with. However, workers are never perfectly monitored because the cost of such measurement exceeds the gain it would generate. As a result, some shirking takes place and the wage is lower because of it. Rather than have the machine owner hire the labor under a wage contract, both owners might cooperate through a share contract. We will discuss share

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contracts in detail below, but for the moment it is sufficient to note that such a contract provides both parties a share of the output, a portion – but not all – of their marginal product. The worker in this situation still has an incentive to shirk, but it is not as strong as it is in the wage contract because labor effort now yields some reward. Since shirking is induced, however, the preceding discussion of the wage contract applies. Too little labor effort is applied to the machine.4 The final type of collaboration is through a fixed rental contract where the worker rents the machine from its owner. Actual output differs from expected output because of random fluctuations and to the extent that the worker alters his own efforts. However, because the machine is assumed uniform, it does not contribute to output variability; apart from the effect of nature, the worker’s expected output varies only as a function of labor effort. In such a case, we say the worker is the full “residual claimant”; barring default, the machine receives a fixed amount, while the worker receives whatever is left over after paying the rent (of course, this difference may be a negative amount). Apart from the random element, the worker’s reward is strictly a function of his own effort. In the case of uniform machines, workers will make the optimal effort under the fixed rent contract, and so this contract will be chosen above the other two. The analysis of the case where machine is heterogeneous but labor (and labor effort) is uniform is the mirror image of the one just presented. When labor is uniform, wage contracts make expected output solely a function of the quality of the machine. Machine owners have the appropriate incentive to maintain and improve their machine and will not gain from misrepresenting its quality. In this case, the machine owners are the residual claimants and are the only ones affected by their own actions. Therefore, the fixed wage contract would be chosen because it maximizes the value of production net of the transaction costs. Note that in both cases, a share contract produces less net wealth for the contracting parties than some alternative. When labor was uniform, the wage contract was best; when the machine was uniform, the rental contract was best. Under the unrealistic assumption that one input is uniform, a share contract is a puzzle. THE SHARE CONTRACT AND CHEUNG’ S CONTRIBUTION

Eliminating either the variability or alterability of a single margin or removing nature from production means that transaction costs can also be eliminated through the particular property right distribution that assigns residual claimancy to the appropriate owners who can alter attributes. Thus, if labor is the only variable input, then laborers should be the full residual claimants and 4

Recall that we are assuming machines are uniform and unchangeable, and so there is no shirking on the part of the machine owner.

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rent the other inputs. If some other input is the only variable input, then that input rents the others and owns the property rights to production. It is useful to take a step back and discuss this shortcoming in terms of the historical economic treatment of share contracts, where economists had generally concluded they were universally inefficient. As mentioned, a share contract is where multiple owners of inputs combine them in production and share the output in some fashion. In the context of farming, a landowner lets a farmer work the land in exchange for a share of the output. Most share contracts are quite simple and have simple shares like 50:50 or 60:40. Sometimes other costs might be shared along with the output, and sometimes there might be fixed side payments as well.5 The economic analysis of share contracts goes all the way back to Adam Smith who was no fan of sharing. In a section called “Discouragement of Agriculture” in The Wealth of Nations, Smith gave an historical overview of farm contracts from ancient times to the American Revolution and repeatedly connected the incentives of sharing with those of slavery. Slavery on farms ended, according to Smith, because of the slaves’ disincentives to provide effort and look after farmland and farm equipment. These same incentives, Smith suggested, were present on farms with share (metayer) contracts. Smith stated: To the slave cultivators of ancient times, gradually succeeded a species of farmers known at present in France by the name of metayers. They have been so long in disuse in England that at present I know no English name for them. The proprietor furnished them with the seed, cattle, and instruments of husbandry, the whole stock, in short necessary for cultivating the farm. The produce was divided equally between the proprietor and the farmer. (1994, p. 366)

One of Smith’s lasting contributions to the economic understanding of sharing was the application of the tax metaphor for the effect of the share on behavior. The tithe, which is but a tenth of the produce, is found to be a very great hindrance to improvement. A tax, therefore, which amounted to one-half, must have been an effectual bar to it. (1994, p. 376)

The treatment of a share as being “just like a tax” would last in economics for the next two hundred years. When the farmer’s payment to the landowner is likened to an ad valorem tax, then it is easy to conclude that the share contract is inefficient when compared to self-ownership or fixed rent contracts.6 5 6

See Allen and Lueck (2002) for an extensive discussion of share contracts in agriculture. See Câmara, and Santos (2016) for an examination of complicated vineyard share contracts. Economists historically never claimed the fixed-rent contract as inefficient because they implicitly assumed the land (inclusive of the improvement and equipment that accompanied it) was unchangeable. On the other hand, economists were quick to criticize Henry George’s single-tax proposal, pointing out that since his assumption that land was unchangeable was too unrealistic, his policy conclusions were rendered useless. Had economists been consistent in recognizing in all their applications that land is changeable, it is less likely that the share contract would

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Marginal product MPL

(1-s)MPL w

LT FIGURE

L*

Farmer labor

6.1 The effect of a tax on the level of farm labor

Consider first the analysis of an ad valorem tax. The demand facing sellers of a taxed commodity is lower than the consumers’ demand by the amount of the tax. Because of the shift in demand, the market equilibrium quantity under the tax is less than it is in the absence of the tax. The tax, then, distorts resource allocation: under the tax, the marginal unit transacted is valued more than it costs; expanding production would produce a net gain. The tax, however, creates a wedge between consumers’ and producers’ incentives, thus preventing the realization of that gain. Economists argued that this tax analysis applies directly to the share contract. Consider Figure 6.1 where the value of the farmer’s marginal product on a plot of a given size is MPL . His market competitive wage is w; that is, the farmer can sell in the market as many units of labor as he wishes at the wage w. Were the farmer self-employed, he would apply L∗ units of time to the farm. The landowner, however, receives a share, s, of the output. The farmer whose share of the output is (1 − s) retains only (1 − s) of his own marginal product and will apply LT units of time to the farm to maximize his wealth. This analysis appears identical to the analysis of an ad valorem tax. For units of labor between LT and L∗ , the marginal product of the farmer exceeds the wage rate. The farmer, however, will prefer to sell these units of labor service in the market because his share in the farm output is less than w per unit of labor. Such farmers, then, will stop short of producing the output where the value of their marginal product equals their alternative earning. The shaded area in Figure 6.1 is the alleged inefficiency induced by the share contract, which is likened to the tax distortion. As pointed out by Cheung (1969), this analysis is seriously flawed. Given the farmer’s share of (1 − s), LT appears to be the farmer’s optimal level of have been singled out as the only inefficient tenure contract. Either the fixed-rent contract would also have been considered inefficient or both contracts would have been recognized as efficient.

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Marginal product MPL

(1-s)MPL w

LT FIGURE

L*

Farmer labor

6.2 The transfer of wealth from sharing

labor input. However, if the farmer is free to apply as much labor as he wishes, he can increase his income by becoming a share-farmer on two farms and spending half of LT units of time in each.7 Indeed, the farmer will do best by working a tiny bit on many farms. This, of course, is never observed. Another problem is that when the farmer receives (1 − s) of the output produced by LT units of labor, he receives more than his opportunity cost of working in the market at wage w.8 This means the farmer earns a rent equal to the cross-hatched area in Figure 6.2. Since no farmer owns the right to this rent, it is in the public domain and efforts will be made to capture it. Competition over capture can take many forms, but at the margin, farmers must compete the rent away, and the subsequent transaction cost lowers the value of sharing even more. Finally, since the amount of labor per acre applied to farms under sharing is lower than what would be applied under a rental contract or an owneroperator farm, the yield per acre must be lower.9 Under all of these conditions, the share contract could never survive in agriculture. These absurd results indicate that this model suffers from an internal inconsistency. The incoherence of the traditional analysis of sharing stems from a series of assumptions. As discussed above, sharing is inefficient when there is only one margin to adjust: Labor time, and this time is observed at zero cost. Although there is presumably land being used in production, this land is fixed, simple, and nonvariable. With only one margin, sharing only leads to costs and should never be adopted. 7 8 9

Income is higher because the marginal product of the farmer is higher now that his labor is applied to two farms of fixed size rather than one. The area under the line (1 − s)MPL , up to LT , is the income to the farmer. The opportunity cost to the farmer is w × LT . The best evidence shows that there is no difference in the yield per acre between farms operated under share contracts or rent contracts. See Braido (2008).

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Other assumptions are embedded in the traditional analysis. First, landowners find it prohibitively expensive to stipulate and police the amount of labor input, even though this labor input is observable. If they could specify, they would choose L∗ and a share that would cover the farmer’s opportunity cost. The farmer would accept, and the share contract would be equivalent to other forms of collaboration.10 Second, landowners encounter no cost in policing the receipt of their share of the output. When the farmer splits the crop at the field, how does the landowner know that the split is what was agreed upon, or even if the quantity is right, that the quality is correct?11 Implicit in the traditional approach are the assumptions that the cost of monitoring output is always zero and that the cost of specifying labor input is always prohibitive: These assumptions are ad hoc and false. In reality, all inputs lack uniformity to some extent, inputs are complicated with multiple and alterable attributes, and nature always plays some sort of role in terms of both random shocks and seasonal variations. It follows that all types of contract forms (which determine the economic property rights of the parties to the exchange) are subject to transaction cost problems. When discrepancies between costs and valuations are inevitable, an arrangement in which such discrepancies are observed cannot be thought of as inefficient per se. Inefficiency implies preventable waste – waste that would not occur if people were to maximize. In an imperfect world, even the best solution is still subject to discrepancies between marginal costs and marginal valuations; not all such discrepancies should be eliminated. COLLABORATION WHEN ALL INPUTS ARE VARIABLE AND ALTERABLE

In keeping with the farming example, let us consider the case where both land and labor inputs vary in nature and are alterable by the owners. In this case, both owners stand to gain as a result of cooperation between them, but each can also exploit the other through some margin.12 Also assume that the contract terms are determined by competition and, therefore, maximize the joint 10 11

12

This was the method Cheung (Chapter 2, 1969) used to show the equivalence of two contracts. This is also likely the first formal demonstration of the Coase Theorem. Interestingly, Smith was keen to point out the issue of the problem of measurement with cropsharing and noted (p.367) that “In France, where five parts out of six of the whole kingdom are said to be still occupied by this species of cultivators, the proprietors complain that their metayers take every opportunity of employing the master’s cattle rather in carriage than in cultivation; because in the one case they get the whole profits to themselves, in the other they share them with their landlord.” This is often called “double moral hazard” (Eswaran and Kotwal (1985), Bhattacharyya and Lafontaine (1995), Agrawal (2002)). When only one party has the power to alter (multiple) margins, we have “multitask agency” (Holmstrom and Milgrom (1991). In the Holmstrom and Milgrom model parties are assumed to be risk-neutral and the agent has multiple margins to adjust. The principal has none. These models showed that risk aversion is not necessary for a model of contact choice.

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wealth of the exchange net of the associated transaction costs. Thus, in spite of any marginal inequalities, the contracts are constrained efficient. Contracts explicitly specify some attributes of the transaction (e.g., the number of acres leased). To have meaning a specified attribute must be measured to some minimal extent in order to be explicitly priced. On the other hand, contracts will leave unspecified many attributes that are too costly to measure, and these attributes are necessarily unpriced.13 Among all the attributes, some are subject to control by one party and some by the other, that is, by the parties holding the economic rights to the attributes. Unspecified and unmeasured attributes will be exploited by the contracting party that controls them; specified and measured attributes may also be exploited.14 In order to focus on the analytical issues at hand, we will assume that only the unspecified and unpriced attributes are exploited. The Fixed Rent Contract A fixed-rent land contract normally stipulates the area, duration, and rent; however, in principle, it can be as detailed as the contracting parties wish it to be. Whereas the parties are free to stipulate whatever they wish, not all attributes are worth stipulating and monitoring. Any attribute that is not stipulated and that can be varied becomes a free attribute to someone. Farmers who are in control of such an attribute will use extra units so long as they generate added positive (net) income; landowners will similarly use attributes under their control to their own advantage. When a farmer rents a plot of land on a fixed basis, the unspecified soil nutrients are under his control, permitting the extraction of whatever amount is wished without paying a marginal charge. On the other hand, other elements of the land, like infrastructure maintenance or land improvements, remain under the landowner’s control and are not priced on the margin either. Because each party to the exchange makes choices out of line with the costs of those choices, neither makes decisions that equate actual marginal costs and benefits. The three panels of Figure 6.3, depict different aspects of our stylized land rental contract for two alterable attributes. We use this to analyze the nature of the equilibrium, the forces that lead to it, and the transaction costs that result. Panels A and B consider behavior within the exchange on the two margins open 13

14

This dichotomy between specified and unspecified attributes is still too simple. Contracts often implicitly specify attributes through the use of clauses that are governed by common law. For example, in agricultural land leases the inclusion of “good husbandry” clauses make reference to court rulings that rule out specific types of land use (Allen and Lueck 2002). An example of a measured but exploited attribute for land is “acres.” Written land leases always specify the number of acres leased; however, any given land parcel may have irregularities or standing water that vary from year to year. The landowner can verify the acres actually used through costly and imperfect aerial surveys or trust the farmer’s reported acres used based on imperfect tractor measurement devices. Imperfect and infrequent measurement means that a farmer may get away with using more land than contracted for.

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A: Per-acre cost of and demand for soil nutrients $/acre DN

CN+LN U

}

uo

LN CN

N= per acre amount of extracted nutrients

NR

NO

B: Per-acre cost of and demand for maintenance $/acre DM

CM

to T

MR

MO

M = index of quantity of maintenance per acre

C: Market for land under fixed rent contracts $/acre

{

U+T

Q(U+T)

W

L = land in acres QR FIGURE

QO

6.3 Transaction costs of land rental contract

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for manipulation: the choices of land nutrients and maintenance.15 The bottom panel C relates the information in the top two panels to the land market, where land acres are the (measured) priced attribute. The horizontal axis in panel A is the per-acre amount of nutrients extracted from the soil and the vertical axis is dollars per acre. LN is the marginal fall in land value due to the depletion of the nutrients. Although the farmer uses the nutrient for free, its use is constrained by the cost of extraction. CN is the marginal cost of extracting the nutrients – arising, for instance, from particular methods of tillage, the manipulation of stubble, or the application of water or chemicals to transform the nutrient into a form particular crops can utilize. CN + LN is the sum of the two costs. DN is the demand for the nutrients reflecting the marginal increase in the value of output as more nutrients are extracted. A farmer-landowner will extract N0 , the quantity at which DN and CN + LN intersect. Since the land rent contract does not charge for nutrient use, the tenant does not pay, on the margin, for the depletion of the nutrient. He extracts NR , the quantity at which DN intersects CN , the latter being the cost borne by the farmer.16 It is as if the farmer receives an implicit per-acre subsidy at the rate of u0 that is equal to the height of LN , the marginal fall in land value, at NR . Since the farmer depletes the nutrient at the rate of NR , whereas the self-employed farmer-landowner depletes it at the rate of N0 , the per-acre loss due to the farmer’s excessive use of nutrients is the shaded area U. Although the farmer controls the use of the nutrient and is able to extract an “excessive” amount, such as NR , per acre, that control is ultimately at his own expense. A farmer who could somehow commit to use only N0 soil nutrients per acre would produce a lower output. However, he would pay a lower fixed rent such that his net income would increase by an amount up to the area U. As was pointed out earlier, this is a general phenomenon. On average, those able to shirk, to cheat, or to enjoy “free” perks must, under competition, pay for the privilege by an amount that exceeds the expected value of the privilege. The privilege is granted only because it is too costly to eliminate. Panel B of Figure 6.3 shows the per-acre level of maintenance and improvements, assumed to be under the landowner’s control. The horizontal axis is (an index of) the per-acre level of maintenance. CM is that part of the cost of the landowner’s maintenance activity that affects the contract-period crop, and DM is the demand for maintenance within the contract period. Assuming that there are no cross effects between maintenance and nutrients, a farmer-landowner operates at the intersection of DM and CM , providing maintenance at a rate of M0 . When the land is rented out and maintenance is not stipulated in the contract, the landowner does not gain from the contribution of maintenance 15 16

We ignore the choice of labor effort because under the fixed rent contract the farmer has an incentive to provide the optimal amount of effort. Given measurement costs, the tenant will use such nutrients to the point at which the estimated rather than the actual net gain from an extra unit is zero. For simplicity of exposition, such inaccuracies are ignored whenever the consequences are not germane to the argument.

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to current output and will supply an amount of MR .17 It is as if the landowner pays a 100 percent tax on the improvement’s contribution, which amounts to t0 per acre. The per-acre loss from maintenance at level MR rather than M0 is the shaded area T. Panel C in Figure 6.3 shows the market for land under fixed-rent contracts. Were marginal discrepancies absent, D and S would be the relevant demand and supply curves, and Q0 would be the equilibrium quantity. As contracts for rented land fail to price some attributes, there must be an account taken of these discrepancies in the land market. In other words, the priced margin of “acres” must account for the transaction costs caused by the allocation of property rights on the unpriced margins. To simplify, we continue to assume that the discrepancies occur only in nutrients and maintenance. The quantity U + T is the combined per-acre loss to farmers and landowners; it arises from their failure to stipulate and police the use of nutrients and the level of maintenance. Assuming that the average and the marginal losses due to the discrepancies are equal, QR , the quantity for which the height of the demand curve exceeds that of the supply curve by U + T, is the equilibrium amount of rented land. U + T is the loss on the marginal acre. The total loss on the land being rented is (U + T)QR . In addition, there is a loss due to too little farm land being rented, shown as the shaded triangular area W in panel C. The value W + (U + T)QR is the transaction cost of the fixed rent contract.18 METHODS TO MITIGATE TRANSACTION COSTS

The fixed rent contract is a particular distribution of economic property rights between the exchanging parties. This distribution creates incentives to use the unpriced attributes of the land in ways that generate transaction costs in the form of various losses. These losses arise because it is too costly to avert them directly. The property rights hypothesis that wealth is maximized net of transaction costs suggests there is an incentive for the parties to mitigate the transaction costs of the rental contract. This reduction can arise in two distinct ways. First, contract stipulations can limit each party’s scope of property rights over the attributes subject to excessive exploitation or inadequate provision.19 Second, an altogether different contract may be used. Different contracts 17

18

19

MR can be greater than zero because current maintenance, which enhances the post-contract value of improvements, may also benefit current production. A landlord will lubricate his water pump during the current period if it is the most economical way to enhance his income during future periods. Panel C incorporates only two unspecified attributes, one controlled by the farmer and one by the landowner. Generalizing for any number of independent attributes, however, is straightforward. From the perspective of the individual parties, this makes their property rights more incomplete. In this case, a mechanism to enforce contract performance is required. Such a mechanism is usually provided partly by the contractors and partly by the courts. The existence of such a mechanism is taken as a given for the moment.

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involve a different distribution of property rights and, therefore, provide different incentives to exploit the various unpriced margins of the exchange. When an alternative contract produces more wealth net of its transaction costs, that contract will then be chosen. Restrictions on Contractual Property Rights In the conventional analysis of fixed rental contracts, it is implicitly assumed that the asset being rented (land, machines, etc.) is unchangeable. This implies that the asset’s supply elasticities for all unspecified attributes are zero; under these conditions, the fixed rent contract is first-best efficient.20 Although asset attributes can always be altered, it might be possible, at some cost, to fix some of them at an appropriate level. By fixing all attributes at the desired levels, the over- or under-utilization of any attribute is avoided. We can return to the farm land example to elaborate on manipulating land attribute levels in the context of positive transaction costs. The costs of not using the appropriate levels of attributes are borne by the parties to the exchange, and so everyone can gain by constraining their actions in a way that reduces utilization where it would otherwise be excessive and increase provision where it would otherwise be inadequate. To illustrate, we concentrate on reducing the use of soil nutrients, the attribute that is free to the farmer in our example. Limiting Complementary Attributes Suppose, there was complementary attribute to the soil nutrient that was not initially specified in the exchange contract. Suppose that a landowner who farmed his own land would have used the complementary attribute at a peracre rate of W0 , and that the landowner can, at a low cost, fix the level of the complementary attribute when entering a contract with another farmer. Fixing the level of the complementary attribute at W0 will render the cost of using the free nutrient attribute around the equilibrium point less elastic.21 That is, the farmer’s ability to exploit the soil is made more difficult and this will lower the associated distortion. For example, if water use is complementary to the extraction of a soil nutrient, then the landowner can reduce the farmer’s ability to extract the nutrient and reduce the associated distortion by supplying up to W0 water per acre. The effect of fixing the amount of water at no more than W0 is shown in Figure 6.4, which modifies panel A of Figure 6.3. The cost function CN minimizes the cost of extracting the nutrient by utilizing water in the most efficient 20 21

Ignoring matters of risk. This is an application of the Le Châtelier principle (Silberberg and Suen 2001, p. 84). That is, fixing the level of either a complementary or a substitute good reduces the own demand (supply) elasticity compared to when the related good is allowed to adjust.

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$/acre

CN

DN

W0

CN+LN LN CN

NO N1 FIGURE

NR

N= per acre amount of extracted nutrients

6.4 Fixing a complementary attribute level

way. Hence, the cost minimizing amount of water used in extracting N0 nutrients is W0 . When W is fixed at W0 , the costs of extracting nutrients beyond N0 changes from CN – which allowed the farmer to adjust the amount of water freely – to CN |W0 , where W is fixed at W0 . The latter is less elastic at N0 and to the right of it. To the left of N0 , however, the constraint is not binding, and in that region CN |W0 coincides with CN . When W is fixed at W0 , the use of nutrients falls from NR to N1 , which is still greater than what a landowning farmer would use. Therefore, the restriction on water only mitigates the transaction costs. The total loss is reduced from U (Figure 6.3, panel A) to the areas equal to the two shaded triangles in Figure 6.4 (call this U|W0 ). The top triangle results from the fact that the amount of nutrient extracted (N1 ) is still too large. The bottom triangle reflects the fact that the extra nutrients extracted (N1 − N0 ) are not produced by the optimal set of inputs because of the restrictions on the water quantity.22 The landowner may operate on other inputs and impose alternative or additional restrictions, such as stipulating that the farmer must supply minimal amounts of factors that are substitutes for the (free) nutrient, thereby further lowering the demand elasticity (and the quantity demanded) for the nutrient. A similar argument applies to attributes controlled by the landowner. Consider an input complementary to maintenance. If the tenant agrees to supply an amount of that complementary input equal to (or, preferably, somewhat greater than) the amount a self-employed farmer would have provided, the landowner’s supply of maintenance will increase toward its optimal 22

Although W0 is the amount of water used by a farmer-landowner, constraining W to W0 is not the equilibrium. As shown in Figure 6.4, there is still a marginal distortion on the nutrient margin. Lowering the level of water below W0 will lower this distortion. When the water use is lowered below W0 , however, a distortion will occur on the water margin. Given that W0 is the optimal level of water use, this new distortion will essentially be zero (the envelope theorem), but will increase as water is continually reduced. Water will be reduced until the marginal costs of doing so equal the marginal benefits, the result being some equilibrium level of water, W1 , where W1 < W0 .

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amount, thus reducing the loss associated with that factor. For example, the landowner will provide more pumping equipment if the farmer can commit to lubricate it. All of these cases are matters of altering the distribution of property rights within the exchange. When a landowner “restricts” the farmer, the economic right is being removed from the farmer and transferred to the landowner. When the farmer “restricts” the landowner the opposite is occurring. Thus, although all rights may be owned by someone, from each party’s point of view their economic property rights are incomplete. In this case, the increased incompleteness increases the value of the exchange because it limits the transaction costs and increases net wealth. Changing Attribute Prices and Contract Duration Free attribute losses can also be reduced by manipulating the prices of commodities related to the free attributes. For instance, if the price of a substitute commodity of a free attribute is reduced, the demand for the free attribute declines, as will the associated loss. A landowner who wishes to reduce the farmer’s use of an unpriced soil nutrient and finds it not too costly to police the use of a fertilizer substitute may subsidize the farmer’s purchase of the fertilizer. In order to further reduce transaction costs, some commodities that are substitutes for unpriced attributes may be supplied at no marginal charge in order to reduce the use of these attributes.23 Contract duration is another feature that affects the parties’ behavior with regard to attributes. An owner of wheat land may find a one-year rental contract to be satisfactory. On the other hand, in the case of an orchard, it is a different story. The care and maintenance of the trees, which is a task assigned to the farmer, become free attributes to a one-year tenant. Whereas a longerterm rental contract enhances the farmer’s incentive for care and maintenance, thus reducing the farmer’ exploitation of these attributes. Consider a one-year, nonrenewable, land contract.24 Any assets supplied by the landowner (tractors, combines, irrigation, even work animals) will likely be severely depreciated by the end of the year if the farmer controls their use and is responsible for upkeep because the farmer’s willingness to pay for upkeep is reduced to almost nothing. The associated loss is large. If, however, the farmer has to supply such items, there is no incentive to shirk in maintenance. Generally, the farmer gains much more from affecting the value of the capital than the landowner does. Because the farmer – rather than the landowner – owns 23

24

The success of a price subsidy depends on the presence of a particular transaction cost – that of preventing reselling the subsidized commodity. That cost must be high enough so that there is no gain from reselling the commodity. It is very common for land contracts to be single year contracts, with an expectation of automatic renewal. As we discuss below, the expectation of renewal is one form of contract enforcement.

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these inputs he bears any reduction in value, and therefore uses the capital carefully.25 A similar argument applies to land improvements. These may seem to be an integral part of the land and thus a “responsibility” of the landowner. The shorter their effects, however, the less inclined the landowner is to perform these functions while the contract is in force. The problem becomes less acute if shorter-term improvements such as fertilizing and weed control are assigned to the farmer. Thus the contract assigns the shorter-term improvements to the farmer and the longer-term ones to the landowner; the longer the duration of the contract, the further the dividing line moves toward the longer-term improvements.26 Since the effects of the improvements are seldom confined to a particular period, each may be required to provide a minimal amount. The duration of the contract, which is endogenous, often plays a major part in better aligning the parties’ incentives. The duration of the contract is understood to be the length of the period in which the parties cede control of some attributes to each other. Changes in the duration of the contract affect the parties’ incentives to exploit free attributes. This can easily be seen by comparing a farm contract that covers the planting but not the harvesting season with a contract that covers both. Given the shorter contract duration, the farmer is not expected to do any planting, since planting is a “land improvement”: The landowner receives the entire output and the farmer pays all the costs. The farmer’s incentive for planting is restored by extending the contract period to cover the harvest season. The longer the span between planting and harvesting, the longer the expected duration of tenure.27 Ceding Different Rights The task of caring for fruit trees need not be assigned to the farmer, just as equipment maintenance is not necessarily a farmer’s task. Such assignments are a matter of choice: The contractors are expected to assign the provision of particular attributes to whichever party is more suitable. The existence of such a choice points to another aspect of the loss-restraining problem. It may seem that in the land-rent contract it is clear which inputs each contractor furnishes: the landowner supplies the land and the farmer the labor. The recognition, 25 26

27

For this reason carpenters and mechanics often own their own tools while working for others. A landlord may undertake an improvement before signing the contract even if it is optimal to undertake it in the middle of the contract period, since he is not expected to undertake it after the contract is signed. The rent he can charge, however, depends in part on the improvements he provides (Allen and Lueck 2002). The incentive to exploit free attributes intensifies toward the end of the contract period. The more acute this problem, the more likely it is that the parties will sign a new contract before the older one expires. In professional sports, such phasing in of contracts is common both for athletes and for coaches. The motivation is to prevent underperformance by athletes as the expiration of their own contracts approaches, while avoiding the overuse of athletes by coaches whose contracts are about to expire.

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however, that any commodity is a collection of attributes suggests that the real situation is more complex. Improvements, for instance, are obviously not an integral part of the land, and the contractors are free to decide which party will take charge of any of them.28 More generally, the contractors are free to decide which party should furnish particular attributes. With regard to each attribute, one might ask: Which of the two parties will be more inclined to affect the (net) value of output by manipulating that attribute? The principle applied earlier to labor and land applies to individual attributes as well. If the party more inclined to affect the outcome by varying the level of an attribute is put in control of it and becomes the residual claimant of its variability, then losses will be minimized. If, for example, land is rented out on an annual basis, the maintenance of long-lasting improvements will tend to be placed in the landowner’s charge, since landowners are the chief beneficiaries of proper maintenance because of the higher rents they will be able to charge in future periods. Changing the Contract Form A fixed rent contract distributes a particular set of economic property rights between the exchange parties. The actual distribution of economic rights determines the use of each attribute, the total amount produced, and the losses that result from the over or under use of a given attribute. The parties of a contract can place restrictions on the unpriced attributes that can curb misuse, but the losses will not be eliminated. Under such a circumstance, a different contract (a different distribution of property rights) might provide a higher level of wealth than the fixed rent contract. Changing the unit under which the transaction is conducted can alter the assignment of responsibilities. Such a change in units affects the whole distribution of property rights, and the associated incentive system. In the case of land rentals, a contract can use acres as the basic transaction unit (the rental contract), or it can use farmer time as the basic unit – the employment contract. Shifting from one contract to the other constitutes a global change in the incentive structure, and completely alters the supply and demand of the various unpriced attributes. For instance, since an employed farmer’s pay is not, on the margin, a function of output value, he does not gain from exploiting the soil nutrients. This change will, in turn, affect the nature of the output – indeed, even the choice of what to produce. A switch from one contract form to another may even alter the desired characteristics of exchange partners, 28

If landowners are legally required to keep certain improvements present on the plot at the time the contract is signed, there is no need to spell this out in the contract. Similarly, if a landowner plans to maintain the improvements, he will not require such maintenance from the farmer. Some contracts may appear to be lacking in detail but may, nevertheless, differ significantly from similarly worded tenancy contracts in areas in which the particular improvements are simply absent.

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leading to new contracting parties. The basic character of the problem, however, remains unchanged. Each party will overuse those unpriced attributes that are both controlled by them and subsidized by the other party, and each will reduce the supply of those unpriced attributes which they subsidize. The wage contract, for instance, seldom stipulates all workplace amenities, and the employer is expected to shirk in providing them. The decision of whether to adopt a land-rent or a wage contract depends on which one maximizes the total wealth of production net of the transaction costs they create. Leaving aside, for the moment, the discussion of sharing, it is clear that the two contracts cannot be compared marginally because it is an either/or choice. Indeed, every contract type is subject to problems of nonoptimal use; therefore, no single contract is ever best under all circumstances. Hence, the change in any contract form is always all-or-nothing. Thus, a comparison between contract forms must be “global”: Total net values must be calculated, and the contract that maximizes the net value of the resources is expected to be adopted. Since it can be known how the value of a given contract changes when conditions change, the optimal contract chosen can be predicted. For example, the more valuable the land attributes are, the more likely it is that the wage contract will be adopted over the fixed rent contract.29 In general, conditions can be spelled out under which a switch from one form to another is likely. Turning to the three contract forms, one refutable implication is that when market wage rises relative to land rent, the contract form will shift away from the wage contract, which induces a (relatively) careless use of labor, to the land-rent contract (though perhaps first to the share contract), which induces a relatively careless use of land. BACK TO THE SHARE CONTRACT

The share tenancy contract stands between the fixed-rent and the wage contract. When sharing, both landowner and farmer are residual claimants because each is remunerated by a fraction of the reported crop. Sharing is selfenforcing because each party has a partial stake in the residual. One enormous advantage of this is that a single share of the output polices shirking on every input margin. At the same time, because the stake is only partial, each party gains from shirking a little on every single input margin as well. The landowner will not maintain land improvements as vigorously as he would have under the wage contract, and the farmer will not work as hard as he would have under the fixed-rent contract. With the share contract every margin is subject to the partial selfenforcement, and so there is partial distortion on every margin. Although 29

Dairy cattle can be considered an attribute of the dairy farmland. Care and attention to dairy cattle is difficult to measure, and dairy farmer-landowners use hired wage labor to assist in milk production.

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more margins are subject to distortion when the contract calls for sharing, the loss from each distorted margin is reduced more than proportionately. This is different from the other two contracts where the parties only distorted those margins on which they could exploit the other party. Adopting a new perspective on the previously discussed tax analogy may demonstrate how the share contract can result in a lower level of distortions than that associated with the other two contracts. The analysis of tax distortions is standard fare in the taxation literature. It is well known that the distortion associated with a tax (or with a subsidy) rises as the square of the tax (or subsidy) increase. Thus, if a 5 percent tax on a commodity is doubled to a 10 percent tax on the same commodity, then the new welfare-loss triangle is (approximately) four times as large as the original one. In the wage contract, to the extent that supervision is not perfect, the reduction in effort is a free attribute available to the farmer, because the farmer is not penalized for the reduced effort. It is as if the farmer were to pay a 100 percent tax on the increase in output induced by greater effort. Similarly, under the fixed-rent contract it is as if the farmer were to receive a 100 percent subsidy on soil nutrients and the landowner were to pay a 100 percent tax on land improvements, yielding returns within the contract period. In a share contract the taxes are reduced from 100 percent to the farmer’s share in the case of the extra effort and to the landowner’s share in the case of the maintenance expenses. Since the deadweight loss rises quadratically with the tax rate, the rate reduction brought about by sharing results in a more than proportionate reduction in losses. For instance, a fifty-fifty sharing arrangement would reduce the distortions from each of the taxed attributes to one-fourth of their levels at the 100 percent tax or subsidy. The proposition, however, does not apply to the subsidized attributes, since these continue to receive a 100 percent subsidy. For example, to the farmer the nutrient is fully subsidized under both the fixed-rent and the share contract. Whereas all of these items are taxed or subsidized in a share contract, compared with only about half of them being taxed or subsidized when one or the other of the two contract forms is used, the quadratic relationship is capable of lessening the total burden under the share contract to a level below that of the burden either of the other forms generates. Monitoring serves to reduce the losses associated with margins of distortion. The monitoring of each margin of distortion, however, entails its own cost. Since the share contract is subject to more margins of distortion than are the other two contracts, it could have higher monitoring costs.30 In addition to different incentives to distort marginal inputs, sharing output introduces a new problem for the contracting parties. The output must be specified and monitored in order to be shared. When output is shared, the party in control of the output has an incentive to under report both the quantity and 30

If no monitoring takes place, then the share contract will dominate the other two contracts because the share makes the parties partial residual claimants on all margins.

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quality of what is produced. Output might be directly monitored by the other party, indirectly monitored by a third party who purchases the output, or by restrictions on the form of production that reveals the actual output. As stated, all contract types have costs and benefits that arise from the incentives they create. The gains from sharing that arise from the self-enforcement on every margin may not be large enough to overcome the costs of monitoring the output, and the share contract may fail to be adopted. As conditions gradually shift, favoring, say, the wage contract over the fixed-rent contract, the share contract might become attractive as an intermediate step; nevertheless, because of the required extra monitoring costs, the share contract may also be skipped altogether.31 As the fixed-rent contract becomes less attractive, the fraction of rent contracts is expected to fall and the fraction of wage contracts is expected to increase, but it is not possible to state, a priori, whether the fraction of share contracts will increase or fall. EMPIRICAL EXAMPLES ON CONTRACT CHOICE

Allen and Lueck (2002, 2008) have extensively considered the choice of contracts in modern agriculture. In the case of crops grown in North America, they find that the ability to monitor labor effort is so hindered by the large role of nature that wage contracts between farmers (not farm laborers) and landowners are nonexistent. Rather the contract choice is between crop sharing and cash rent contracts. They find that when soil exploitation is a serious problem that share contracts are more common because they “tax” the farmer’s incentive to exploit the soil. This happens when farmers have access to the soil through tillage, cultivation, and multiple rotations of crops per year. An extreme case of crop sharing is found with sugarcane, a crop that requires intensive manipulation of the soil.32 When farmers have less access to the soil, as in the case of grass crops, the contracts are more likely to be rented for a fixed cash payment. Allen and Lueck also find that crops sold through centralized grain markets, where the output is measured, are more likely to be controlled by share contracts than cases where the output is sold off the farm. Allen and Borchers (2016) provide an interesting out of sample test of the Allen and Lueck model. Starting in the late 1990s farmers across North America began using “no-tillage” techniques for growing crops. This involves the 31

32

As the value of the contributions of the two parties becomes more equal, a sharing arrangement is more likely to emerge. This is because fifty-fifty sharing tends to yield the highest reduction in distortions and is also simpler to monitor the split in the output. In the Fraser Valley of British Columbia, farmers growing corn on a 50–50 basis often harvest eight rows of corn (based on the size of their harvester), then skip eight rows and harvest the next eight rows, and so on. The field is then left for a day, and the following day the farmer cuts the remaining alternating rows. In between the two harvesting days, the landowner drives by. A simple visual inspection shows that he will receive not only fifty percent of the crop, but the average quality as well. Interestingly, sugarcane production is very stable and not subject to a great deal of risk. A model of contract choice based on risk would predict less sharing not more.

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use of genetically modified seeds that allow the farmer to plant directly into the previous crop stubble, avoiding the need to plough and cultivate the land. Since no-till agriculture eliminates the farmer’s access to the soil, it takes away the ability to overuse the unpriced soil attributes and eliminates the benefits of using crop sharing contracts. Using data from across all regions in the U.S., across a dozen crops, and over more than a decade, they find that there has been a drastic switch in the use of fixed-cash-rent contracts following the adoption of no-tillage techniques.33 There are many non-agriculture related studies on contract choice. Leffler and Rucker (1991) examine timber sales on tree lots. The owner of the trees can hire loggers, but they shirk; they can sell the trees for a fixed fee, but this requires the trees to be measured, leading to excessive measurement, or the trees can be sold on a per unit basis, which lowers the measurement problem but reduces the logger’s incentive to work. No single contract type dominates the others under all circumstances. However, as the variability of the lot increases, they show that per unit sales are more likely. Chisholm (1997) examined whether or not actors were paid in terms of royalties or fixed payment contracts, finding that the more impact the actor had over the value of the movie, the more likely they were paid a share of the royalties. Hence, royalties were more likely in sequels and when the actor had won an Oscar. Allen (2007) showed that during the Klondike gold rush at the end of the nineteenth century, miners and mine owners cooperated through either wage contracts or shares of the gold mined. In this case, the extreme weather conditions forced miners to dig in the frigid winter, and this essentially eliminated the ability of miners to steal gold because the excavated dirt froze upon extraction. Sharing provided an incentive to work and not shirk in scorching heat during the summer when the gold was removed from the mined soil, but given the value of the gold and the inability to mine small claims, sharing often led to an over compensation. Therefore, sharing was used on creeks where there was a known lower density of gold. Once large equipment made it into the Klondike area, mines were no longer dug by hand. This removed the need to incentivize miners to dig, and the wage contract replaced the sharing contracts. To apply the theory of economic property rights to contract choice requires an understanding of the dirt-level details of the contract. These details allow 33

Grapes are a complicated crop and vineyard contracts reflect this. Grapes require specific soils in terms of fertility, acidity, heat retention, and type. Quality also depends on vine density, row direction, vine training, pest control, canopy pruning, and harvest timing. A small lapse in attention to detail – on say the sugar-acid balance at harvest – can lead to an enormous change in grape quality (Allen and Lueck 2019). Not surprisingly, vineyards have historically been small family-farm operations, but when land is rented modified share contracts are used. Câmara, and Santos (2016) examine colonia contracts in historical Madeira, Spain, for vineyards. These were share contracts on the grape crop, but the tenant farmers owned all improvements to the land (walls, buildings, vines and other infrastructure). This divided ownership allowed for the benefits of renting while creating incentives for the tenant in line with an owner-operator.

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an understanding of why transaction costs might be higher on one margin and lower on another. Such detail prevents anything like a serious summary of the literature. However, whether examining revenue sharing (Gil and Lafontaine, 2012), joint ventures versus networks (Ménard, 2012), or changes in shares on fisherman performance (Espinoza, 2015), there is ample evidence that the choice over how property rights are distributed across exchange parties importantly depends on the transaction costs that each distribution generates. Other Empirical Implications The property rights model of contracting generates many implications, even at the general level discussed here. Because information costs are at the heart of high transaction costs, let us consider two information implications: the introduction of a new use for the physical asset and the arrival of new workers. Imagine a new use for a general type of machine becomes profitable, but information on how a specific machine performs in this new use is costly to obtain. Owners of a specific machine who use it in the new use may also wish to lease the machine out to other potential users. The owners will, as a rule, know more about their machine in this new capacity than potential renters. Because owners are also the main beneficiaries of good decisions regarding the new use, the discrepancy in owner-versus-renter knowledge for the new use is likely to be higher than it was for the old use. Laborers who are offered fixed-rent contracts may suspect that the rent asked by owners’ is excessive and that the owners’ are exaggerating the productiveness of their machines in the new use. Such suspicions are hard to allay; hence labor demand for machine is likely to be low. Wage contracts are free of this particular problem because machine owners who pay fixed wages bear the entire new-use risk, about which they are better informed than are laborers. Machine owners who switch to the new use are more likely to offer wage contracts. In addition, it is expected that with the passage of time the direction of the trend will be reversed: The cost of determining the suitability of specific machines for the new use will decline, inducing the readoption of fixed-rent contracts where they were preferred before. Another information problem arises concerning immigration. Little is known about how workers who are new to an area will perform. Owners of nonlabor assets are reluctant to commit themselves for paying new workers the prevailing wage. Given the lack of knowledge regarding workers’ abilities and attitudes, the demand for their services and, consequently, the wages offered are likely to be low. A new worker who believes that he is more productive than the wage can “guarantee” his output by offering to operate as a fixed-rent worker. These workers, then, bear the onus of the information problem. It is expected that relatively more new workers than established ones will operate as fixed-rent workers. Moreover, new immigrants will be given non-physical assets that are more difficult to exploit, such as those containing few improvements. Some old-time workers may acquire a reputation for being

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gentle on assets and on improvements; these individuals will be the favored fixed-rent workers on the easy-to-exploit assets. Newcomers do not have such reputations and are therefore expected to get assets for which the lack of information makes less difference. Here, too, the trend is expected to be reversed as the new workers become more established. CONTRACT ENFORCEMENT

Throughout this chapter we have assumed that margins specified within a contract were enforced by the state. We now turn to a brief discussion of enforcement through contract law and reputation.34 Legal Property Rights As noted in Chapter 2, economic property rights – the ability to exercise choices – depend on one’s legal rights, the authority one has under the law to make those choices. Although the state never enforces legal rights perfectly, what enforcement there is (along with the threat of enforcement), supports the power to make choices. In other words, at its simplest level, legal property rights increase the strength of economic property rights. All other things constant, more strength leads to greater wealth. At this level of analysis, legal property rights can be analyzed in a straight-forward way. Indeed, this is perhaps the most common way that economists think about property rights. De Soto’s (2000) best-selling book popularized the idea of thinking of property rights in the context of development strictly in terms of a specific bundle of legal rights. Hence the idea of “better property rights” means better legal rights that reduce frictions, improve collateral, and increase trade. Property rights are thought of as something that improves a production or trading process and therefore increases the amount of trading and gains from trade. In this context, property rights are often little more than a parameter in a model. Consider the following example from an influential paper: We assume that property rights are poorly defined in a way that affects the borrowers’ ability to pledge their wealth as collateral. We introduce a parameter τ that captures this. (Besley, Burchardi, Ghatak 2012, p. 241)

In such instances, legal property rights are a black box where the channel of their effect is hidden. In any given model, there may be some constraint on trade, ownership, the ability to post a bond, or some other limiting feature, and “better property rights” are modeled by a parameter that relaxes the constraint. Not surprisingly in this context, stronger legal rights – other things constant – predict greater levels of wealth. Empirically such stronger rights also appear to be a robust driver of development.35 34 35

This section is related to Chapter 8 on institutions. The empirical literature in this area is large. See Besley and Ghatak (2010) for a survey.

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Here, we are more interested in the actual distribution of property rights and how legal rights might lead to a change in this distribution. As discussed above, contracts involve the exchange of goods that have many attributes, and attributes that are not specified are in the public domain and subject to capture. Legal rights are enforced by the state, and this requires the state to observe and measure the margin of enforcement. Such an ability plays a large role in the design of contracts by constraining the margin on which the contract is specified. Specifying a contract in terms of units traded, delivery dates and times, or product quality can only be enforced through legal rights if those particular dimensions can be observed at some reasonable cost. This cost of measuring, therefore, partly determines which attributes of the exchange are unspecified and lie in the public domain. Which attributes are in the public domain, greatly influences the transaction costs of the contract and, therefore, the form that the contract takes. Allen (2012) provides a book length treatment of the massive changes in the ability to measure all sorts of things that occurred during the Industrial Revolution. During the pre-modern era there was great difficulty to accurately measure fundamental quantities such as time, distance, volume, and weight.36 Such an inability created a serious constraint on what type of contracts could be enforced by the state. For example, consider the difficulty of accurate time measurement. Although a horological revolution took place between 1650 and 1750 that saw errors in clock-time fall from 500 seconds per day to about .1 seconds per day, the precision of clock-time only slowly became culturally embedded. “People could take precision or leave it, and often they left it” (Glennie and Thrift 2009, p. 276). For ordinary folks of the early eighteenth century, their day was regulated by sunrise, noon, and sunset and the town bells that marked those moments. Clocks existed, but they were large, communal, and mostly aural affairs that were not accurate to a practical degree. Watches, even with a second hand, were not uncommon, but not readily accepted by the average citizen. The inability to have cheap and accurate time measurement meant that longitude and location could not be easily known (especially at sea), and that standardized measure of distance, weight, and volumes were not available (Landes, 1983). Hence, until the mid-eighteenth century when pendulums and balanced springs reduced the variance in time keeping significantly, and until the late-eighteenth century when accurate clock-time had penetrated most parts of society, the concept of being at a specific place at a specific time was not part of the general culture. Life was, as it had always been, a matter of “by guess and by God.” The result of this inability to measure fundamental things led to various contractual relations that strike us today as not only odd, but outright matters 36

See Chapter 2 of Allen (2012), or Glennie and Thrift (2009).

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of corruption. Government offices were handed out to people who could be trusted (aristocrats), other government offices were sold to the highest bidder (e.g., military commissions), and many labor contracts were in the form of master-servant relations and indentured servitude. These odd relations resulted from the inability of the state to enforce anything like a modern private contract in their particular circumstances. In contrast, the end of the long eighteenth century saw radical changes in the ability to measure fundamental quantities. The chronometer, barometer, mercury thermometer, and reflecting telescope are a few of the measurement devices that were perfected by the end of the century. Along with theoretical and scientific developments, these innovations allowed for inexpensive and standardized printing, machine tools, and processes. These changes allowed the ability to connect inputs with outputs in a reasonable way for many occupations and allowed the notion of accountability to become embedded in the culture to a degree previously unknown. As a result, there was an increase in official records, a desire for sound information, an emphasis on statistical measurement in administration, an understanding of being at a specific place at a specific time, that had never existed before.37 When hours could easily be measured, wage contracts could be entered into and enforced by the state. When weights and measures were easily measured, the state could enforce contracts based on quantities and delivery times. Much of our modern world rests on the state enforcing legal rights on particular margins, and this came about because of abilities to measure basic things that today we take for granted. Legal rights of contract are themselves matters of choice and can be thought of as an allocation of rights designed with a wealth maximizing objective, net of the transaction costs that they entail. As such, legal rights are also amenable to the application of the property rights approach. Generally speaking, exchange is wealth enhancing, and so it should come as no surprise that the general law of contract encourages exchange. However, the law also recognizes that there are transaction costs with exchange, and contract law attempts to mitigate these costs. Contract law helps prevent cheating and theft through contract with concepts of “good-faith” and “best-effort” which allow for a contract to not be enforced when one of the parties fails to meet these conditions. Contract law allows courts to establish standard contract terms when they have a comparative advantage to do so and allows for standard references that can fill in details of a contract easily. For example, we earlier referenced a common farmland lease clause that states the farmer will behave in a “good and husband like manner.” Such a term seems meaningless, but actually references a body of common law on behaviors that are unacceptable on the part of a farmer leasing crop land. Thus, rather than spelling out an incomplete list, contract law allows for an easy way to reference many court decisions on behaviors that have been determined unacceptable. Contract law 37

Baker 1973., p. 217.

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also allows for breach of contract, and assigns liability in ways that result in efficient breaches. It is beyond our scope to provide a detailed discussion of the economic logic and organization of contract law.38 However, consider one example that highlights the property rights hypothesis: penalty clauses. A penalty clause is an excessive punishment for not fulfilling a contract, and is generally not enforceable in law. Suppose an online book seller had one of the following deals with its book customers: i) if the book is not delivered in two days, it is free; or ii) if the book is not delivered in two days, the seller will pay $10,000. The first contract is enforceable under the law, and the free book is considered a reasonable estimate of the damages caused by the late delivery. The second contract is not enforceable because the penalty of late delivery is “excessive.” Why should the law care about whether the penalty is excessive? The penalty clause seems to provide the book seller with a strong incentive to fulfill the contract and deliver the book on time. Interestingly, if the contract had an incentive clause that said “if the seller delivers the book within two days, the customer will pay the seller $10,000,” that would be enforceable! The puzzle disappears when one considers the transaction costs involved. The penalty amount is in the public domain to some extent. The customer can attempt to capture the $10,000 by engaging in behavior that makes late delivery more likely. Perhaps the customer gives the wrong address or sabotages the delivery vehicle. That is, the penalty clause encourages transaction costs and lowers the value of exchange. The incentive clause does the opposite, the way the book seller collects the $10,000 is by executing the contract as specified. Thus, it makes sense that one rule is not enforced while the other reciprocal rule is enforced. Reputation When contracts are not enforced by the state, they must be self-enforced. Legal scholars call these types of agreements “relational contracts.”39 In such a case, the parties to the contract trust each other that they will engage in mutually beneficial actions, and not seek to misuse the unspecified attributes of the traded good(s). These types of contracts exist in market exchanges, but also in relations within firms and other types of organizations. Even when some margins of a contract are enforced by the state, other margins might be enforced through trust. Why should one party trust another? The answer, of course, is that the relationship gets designed such that it is in the interest of both parties to act in a trusting manner. Relational contracts are thought to arise in situations where the parties have an on-going relationship (Axelrod, 1984). In each encounter there is an incentive to renege on any agreement and cheat the other party. However, to do so would mean the loss of all future cooperation. If the 38 39

See Friedman (2000) for an excellent example of this. This originates with Macneil (1969) and subsequent work.

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relationship can be designed such that the threat of losing the wealth from future cooperation is greater than the gain from any one-time exploitation, then trust claims are self-fulfilling (Baker, Gibbons, and Murphy, 2002). An extreme example of relational contracting is found in the British Navy during the age of fighting sail (c. 1500–1840). During this time, there was a serious trust problem with the ship’s captain. Captains controlled their ships on the high seas at a time when the Admiralty could not directly monitor them. During the age of sail, communication was intermittent, slow, and limited; the world was still generally unexplored, with shoals, waterways, and trade winds not mapped; flag signals from other ships were often mistaken, misunderstood, or unseen; and even methods for finding positions of longitude were only developed towards the end of the eighteenth century, and were not widely adopted until the end of the age of fighting sail.40 Worse, given that ships were propelled by wind, any disasters, losses in battle, missed opportunities, and other failures of duty could always be blamed on the ill fortunes of nature. Added to this was the captain’s temptation to seek out private wealth and safety rather than engage in more dangerous and less profitable assignments given by the Admiralty. Thus, there was no direct means of monitoring captains; captains had private incentives to act in ways against the Crown’s wishes; and every failure to perform could be blamed on nature. The situation seems hopeless. There were a number of responses, but critical among them was to create a pay structure for captains that gave them a strong incentive to “do their duty.” The central compensation scheme in the British Navy was an arrangement that rewarded captains if they were successful and remained at sea. This system revolved around the taking of prizes and spoils of war, which were then divided by an Admiralty Prize Court. For a successful captain the system was incredibly lucrative, and a successful captain could gain immense wealth through it. However, any detection that the captain failed to act in a trusting way led to a life on shore under “half-pay,” or worse a trip to the firing squad. The system was known as “patronage,” and it is a stark example of how a relationship not defined by specific measurable margins of performance can still mitigate transaction cost behavior. Rather than losing a future profitable relationship, cheaters in a contract can be punished through a loss of reputation. Reputation is established through investments in specific sunk capital (Klein and Leffler (1980), Shapiro (1983)). This capital investment must be visible to the parties to ensure trust, but more importantly, it must be sunk – something that is lost when others cease to trade because of some type of contract infringement. For this reason, these investments are often referred to has “hostage capital” (Williamson (1983)). It is easy to think of contracts as falling into one of two categories: fully enforced by the state or fully self-enforced. However, consider a typical traded commodity that has numerous attributes. The contract will never specify all 40

Rodger 2004, pp. 382–383.

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of the attributes, even when the state enforces compliance on some specified legal margin. This means that the remaining attributes are implicitly enforced by reputation or relational contracting. Apples at a grocery store are sold by count or weight, but contain numerous other attributes like texture, taste, and sweetness, the latter are only trusted based on the reputation of the grocer. Likewise, an automobile is sold by the unit and many attributes are specified and legally enforced, but most unpriced and unspecified attributes are enforced again by reputation. Reputation then, is an almost ubiquitous method of contract enforcement. THE COSTS OF SOLE OWNERSHIP

We have thus far focused on the costs and gains associated with fixed wages, fixed rents, and share contracts between two input owners. Although different contracts encounter different incentive problems, every exchange, and therefore every contract, is subject to some such problems. The sole-ownership arrangement is free of those contracting problems that arise when inputs are not owned by the same person. It might appear that sole ownership should be the preferred method of operation. However, the sole-ownership arrangement is subject to two sets of costs associated with owning all of the inputs in a production process. The first set of costs are transaction costs that arise because the pattern of ownership of productive non-human assets is extremely unlikely to match fully the ownership pattern of human skills that would generate the highest output. Total output, then, can be increased if people exchange productive assets in order to arrive at a better match of resources. To accomplish this, owners of labor must transact in markets, measure the goods being purchased, and engage in other transaction costs that might arise. Furthermore, the labor owners might have to borrow in order to buy the other assets. Once again, transacting must be reintroduced – here between borrower and lender. A priori, it is not clear that the transaction costs between an owner of labor and an owner of a physical asset are lower in a contract, or across a goods and/or credit market. All human interactions involve transaction costs. Clearly, another cost of sole ownership is that the gains from specialization are sacrificed when one individual owns and uses all of the productive inputs.41 Although sole ownership removes the incentive to shirk, the gains from specialization are eliminated. In order to maximize the return from their land, landowners will engage in such activities as maintenance work and prevention of erosion. The owners of labor will invest in such activities as maintaining and 41

This point was made early on in Eswaran and Kotwal (1985). Allen and Lueck (1998) develop this idea and show that when nature can be removed from the biological stages of agricultural production, wage contracts start to dominate and farms move to corporate forms of organization. Hence, the invention of antibiotics allowed chickens to be raised indoors, and chicken production moved from solely owned small family operations to massive corporations.

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improving their cultivation skills. One person who owns both assets cannot specialize as much as two individual owners of two assets. The notion that land and labor are sufficient to produce output is a gross oversimplification: many production factors determine the output. Farmers are seldom if ever the sole owners of all inputs. A present-day sole-owner farmer in the United States would, among other things, have to own and operate a spray plane and conduct plant research and development. As markets grow larger, the potential gains from specialization increase; any one person then benefits from relinquishing the ownership of various assets (or attributes of some asset) and engaging in contracting with owners of other inputs in order to acquire the corresponding services. The gains deriving from sole ownership must be balanced against the falling output caused by the commensurate lower level of specialization. As always, the objective is to have the distribution of property rights that maximizes wealth net of transaction costs, whether this comes from increased output or lower transaction costs. CONCLUSION

The owners of various inputs can increase the value of their assets by collaborating, because total output is rendered larger than it would be were they to operate alone. However, collaboration is itself costly because it is difficult to prevent wealth capture when cooperation is attempted. Measuring each factor’s contribution to output is necessary for cooperation to be successful. Such measurements are costly and therefore will not be precise. This lack of precision, coupled with the variability in output due to unpredictable factors such as the weather, implies that individuals can gain at each other’s expense and that they will spend resources in order to capture these gains. Together owners of factor inputs (bolstered by competition from other owners) will adopt the contract form that generates the largest net output value where maximization is subject to conventional production costs as well as to the transaction costs associated with wealth capture. No inputs are uniform; specimens of each vary in terms of the levels of their respective attributes. The contract between the owners will therefore attempt to control not only the factors as a whole but also various individual attributes. Some of these attributes may be controlled directly (e.g., a farmer pays for irrigation water supplied by the landowner); those difficult to control directly may be controlled indirectly by fixing quantities and altering prices. A basic principle underlying the maximization process is that individual attributes will be placed under the control of the party that can more readily affect the net value of the outcome by manipulating the attribute. No single solution is best under all circumstances. As a situation changes, the form of contract will tend to change as well.

7 Divided Ownership and Organization

INTRODUCTION

In the previous chapter on contracts, we examined the simplest form of cooperation: two input owners ceding property rights to and from each other in order to produce a good. In particular, even though the inputs contained multiple attributes, any given input was sufficiently small that it could be controlled by one person. We extensively considered the prototypical case of a farmer renting land from a landowner to produce a crop, and other simple acts of productive cooperation governed by both formal and informal contracts. Our emphasis was that the inputs used in production contain multiple attributes, and as the contract may only measure and specify one or two attributes, many are left unpriced and unmeasured. Unpriced attributes become free to be exploited by the other contracting party, and the waste caused by this creates an incentive to mitigate the exploitation. One solution is sole ownership of all inputs, but this results in a loss of specialization and creates other transaction cost problems. Other solutions were to either restrict the types of rights parties had or make discrete changes to the form of contract.1 Each form of contract has a level of output and transaction costs associated with it, and the contract that maximizes the level of net wealth is the one expected to be chosen. The previous chapter did not explicitly deal with the matter of who bears the negative residuals of cooperation. Production by input owners always involves a third party: Nature, which is often random, as in the case with the weather. Nature’s input might increase or decrease output, and depending on the distribution of rights spelled out in the contract, different input owners will bear 1

Another solution to the over exploitation problem is to form long-term relations between the parties. As a rule, long-term relations – as between husband and wife – discourage the exploitation of free attributes. Forming these relations consumes resources, however, and thus whether or not to have them is a matter of choice and of maximization.

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these gains or losses in different proportions. That is, because a contract defines economic ownership it therefore determines who bears the various residuals. This means that the ability to absorb negative residuals will act as a constraint on contracting parties. If party A enters a contract with party B, who is unable to bear all residuals, then those residuals will be borne by party A – whether this was intended or not. In many of the small contracts considered in Chapter 6, the potential residuals were implicitly assumed to be small enough to be absorbed by any party to the contract, and therefore ignored. As the size of the potential residuals increases, however, the ability to bear residuals becomes an important determinant of how cooperation is organized. We now turn our attention to the cases of cooperation where the level of asset and production complexity increases. Perhaps the inputs themselves become larger and more complicated, with many more attributes. Perhaps the number and type of input owners increase. As the level of complexity of production increases, the potential gains from multiple incomplete ownership also increases. Thus, large-scale, complicated assets often have many owners across attributes and types of rights, and the division of this ownership attempts to maximize the value of the assets net of the transaction costs involved. As ownership becomes more complicated and non-price restrictions develop on individuals to manage their actions when their incentives are misaligned with the value of the assets involved, the restrictions start to look like formal “organizations.” Organizations, like firms, act to coordinate the actions of the owners at a lower cost than a price mechanism can. Thus an organization constitutes a distribution of property rights. Depending on the nature of this distribution we get the entire spectrum of organizations from pure caveat emptor exchange to the various forms of firms that are observed.2 OWNERSHIP OF COMPLICATED ASSETS

Large-scale assets (like equipment, or warehouse and retail space) not only consist of large numbers of attributes but often require other inputs (also perhaps with large numbers of attributes) from other maximizing individuals to be used. Since these individuals may attempt to gain at each other’s expense, their interactions result in transaction costs, and the size of these costs depend on the distribution of ownership over all of the attributes of the various inputs. Maximization requires arranging ownership to take such costs into account and reducing their impact. Other things equal, the greater an individual’s ability to reduce the transaction costs through their ownership of a given set of attributes, the more likely that person will assume that ownership, including the responsibility for any variability – if they are able. This means they will tend to assume a greater share of, and thus increasingly become greater residual claimants to, 2

“Caveat emptor” translates “let the buyer beware,” and means the buyer assumes responsibility for a goods quality at the time of purchase.

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the income of the attributes they can mostly affect. Therefore, it is the management of the transaction costs caused by various distributions of ownership that forms the rationale of organization.3 The productive use of a large-scale asset could be realized by a centralizing organization in which all workers are paid a wage per unit of time, and then directed in how to operate the large-scale equipment. Under such an organization the participating workers would have opportunities and incentives to shirk. The losses due to shirking, along with the costs of supervision and monitoring to reduce it, would lower the value of this form of ownership. Alternatively, use of the large asset could be realized by turning each cooperating input owner into a residual claimant of their particular operation, allowing each free, but shared, access to the large-scale equipment. In this case, the individuals operating the large-scale asset need not belong to the same organization; each could assume full control of their niche operation.4 They may accomplish this by each raising capital, purchasing other inputs to use, and selling their output – all while using the shared asset. However, to these users, the independent unrestricted access to the large asset renders it common property. That is, the various attributes of the large-scale asset are in the public domain as far as these users are concerned.5 Herein lies the difference between simple contracting and divided ownership in general. In the case of simple contracting, one person gains access to the ceded attributes of another and exploits them. With multiple divided ownership, many individuals gain access to sets of attributes which results in a common property problem. This is not a matter of each person just overusing free attributes, but each person also competing with others for the exploitation of free attributes. As a rule, the maximizing solution to the problem of using large-scale complex assets is a mixture of the two forms of organization: centralized organization with wage workers and independent owners of complementary assets. Of the resource owners associated with production, several subsets are expected to become residual claimants (owners) to different components of the large-scale operation. Within subsets containing more than one individual, however, individuals will operate as members of centralizing organizations in order to mitigate the common property problems. This is subject to the 3

4

5

This is in contrast to a classic argument that firms exist to exploit scale economies associated with large assets, per se. Economies of scale is neither necessary nor sufficient for the existence of large-scale organization. In a classic study, Allen (1966 [1929]) described how in Birmingham in the 1860s workers engaged in the production of guns were operating independently of each other while sharing space and power sources in large “factories.” Similarly, in some large department stores, individual kiosks are independently owned and rent space from the store. These kiosk owners share the heating, lighting, security, and other attributes of the space provided by the store owner. Following Lueck (1994), we distinguish “open access” as a situation where anyone has access to something in the public domain, and “common property” as a special case where only some set of people have access to something in the public domain.

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constraint of the owners’ ability to absorb large negative residuals, but we will abstract from this until the end of the chapter. Three Examples To illustrate the nature of the effects and control of the common property problem, consider three capital goods: a taxicab, a large machine, and an office building.6 These examples encompass most of the problems that arise when equipment is used, as well as the different methods for resolving them. Problems associated with the use of the first two goods will be described briefly, while the third will be explored more extensively. Although taxicabs are not large, a cab may be operated by two or three fulltime operators who keep the revenue they generate. Consider, for example, the case in which a cab is operated by two individuals who share its ownership and drive it in shifts. The two operate as full-fledged partners, but because they jointly own the cab and each has full access to it they can exploit any of its attributes and consume them as if they were half free. The difference between this case, and the case of the farmer and landowner in the previous chapter is that here each cab driver has access to, and shares in, all of the attributes of the cab, but keeps their earning from their shift. This creates a common property problem over the cab, and the drivers benefit if they can reduce this problem by making certain attributes exclusive property. This can be accomplished by not sharing some of the cab attributes. For instance, the time slots allotted to each owner may be clearly spelled out between the two so that each is the exclusive user of the cab for a given shift. Whether or not gasoline becomes common property depends on the accuracy of the fuel gauge. If it is reasonably accurate, each may assume responsibility for the cost of their fuel. The division of responsibility for the tires depends on how easy it is to keep track of individual mileage (very easy) and tire damage, which depends on the type of road traveled and driving style (impractical). Thus, tires are less likely to become common property than are time slots, but perhaps more likely than is gasoline. Upholstery wear and tear is too costly to monitor, and therefore, it is likely to be common property. Consider, finally, why the engine may become common property. Suppose that engines designed for premium gasoline are well suited for cabs, but these engines can also run (poorly) on regular gasoline. Drivers who share the cab but pay for gasoline will gain by using regular gasoline which prematurely wears out the engine. Even though they are partners they may choose to use regular gasoline because each saves the entire difference in price of gasoline while bearing only half the 6

Divided ownership is not restricted to physical equipment. Until quite recently, many financial assets appeared to be “whole.” In recent years, however, it has been found that they can be unbundled to reveal a rights structure of some complexity. For example, mortgages and bonds can divided up into “tranches,” based on risk, time to maturity, or other characteristics. Different tranches can then be owned by investors with different abilities to manage those financial attributes.

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cost of the resulting engine damage. To prevent this from occurring, cabs are expected to be fitted with engines that use regular gasoline. Cabs will be fitted with engines that require premium gasoline only if a centralized organization takes charge of fueling them.7 Turning to large machines, several workers may be required to make such a machine function. If all of the workers share in the machine ownership, then the absence of constraints on individual behavior will permit many of the attributes of such a machine to become common property. For that reason, incentives for such activities as careful handling and maintenance may be greatly weakened. This problem may be alleviated if many of the individuals who work with the machine become employees of a single machine owner. Not all those working with the machine are expected to be the owner’s employees, however. For instance, the function of servicing the machine may be outsourced to individuals outside the firm if it is easy to measure that service. The preceding examples address common-property problems that arise when the ownership of large assets is divided among individuals or organizations. These examples illustrate the fact that the severity of the capture problem varies from one case to another and, indeed, that the severity of the capture problem is not uniform for different attributes of a single asset. Because different attributes are not equally susceptible to capture, it may be advantageous to handle various attributes differently. Attributes susceptible to serious commonproperty problems, such as equipment lubrication, will tend to be owned by organizations created to control these problems. On the other hand, attributes that are relatively free of such problems will tend to be individually owned. Therefore, the ownership of a capital good is not expected to be vested in a single person or a single organization. The maximizing ownership pattern of individual attributes of equipment is the one that maximizes the value of its production net of the transaction costs of that ownership pattern. Because large-scale, complicated assets often possess major attributes that are susceptible to common-property problems, they will tend to be owned by some centralizing organization – an organization that may be called a “firm.” This firm may appear to conform to the received neoclassical firm, enjoying a scale economy in the use of the large asset. However, unlike the neoclassical firm’s product, the output of the firm is largely determined by the nature of the common-property problems it encounters. When different attributes of a single large asset are not subject to common property problems then they will tend to be owned by different individuals or different organizations with each producing its own output. The capital good “large office building” is a striking example of an asset subject to scale economy, but also where many of its attributes are owned by a number of different people. Office buildings that accommodate many workers contain attributes such as corridors, entrance halls, elevators, and access to 7

If the car had been rented rather than shared, the problem is worse. Hence, rental cars – even high quality ones – are expected to be equipped with engines requiring regular gasoline.

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utilities that suffer common-property problems. These, of course, need to be addressed, but most of the structure can be assigned to individuals with reasonably complete property rights over specific attributes. In this latter case, the building’s users do not have to be severely constrained in order not to damage it, and they can conveniently belong to organizations distinct from others within the building. Large office buildings are owned and used in a radically different way from that implied by the neoclassical model of the firm.8 The legal owner of a large office building is the individual or the organization holding the title to it. Nevertheless, that owner does not usually retain the economic rights to all attributes of the building; their ownership is divided. Likewise, the individuals working in an office building are seldom the employees of the building’s legal owner. Indeed, sometimes the titleholder supplies little more than the coordination of the contracts that govern the use of the building between various firms, each of which owns some of the building’s attributes. The distribution of property rights over a large office building is complex. The titleholder usually rents out office space, thereby legally relinquishing to the tenants a subset of the rights that they previously held; the tenants then become owners of these rights. These tenants, which are often distinct firms, produce distinct outputs that have little to do with either the building or its scale. Moreover, other parties are often granted rights to other attributes of the building. If the building has been mortgaged, the mortgage-holding bank has most likely imposed restrictions on the building owner, thereby making itself the owner of a subset of rights. It meets the definition of “owner,” since it exercises control and becomes a residual loser if the titleholder is unable to make mortgage payments. If the titleholder has retained a janitorial service, the supplier of that service assumes the liability for its operation and is, in turn, the owner of another subset of rights. Given that several organizations hold rights over attributes of an asset such as an office building, the question arises as to the principle that governs the division of ownership. The property rights hypothesis is that the distribution of rights that maximizes the value of the building net of the transaction costs will be the one chosen. Other things equal, this means that the structure of rights is expected to be designed so as to allocate ownership of individual attributes such that the parties who have a comparative advantage in affecting the income flow over the attributes that are susceptible to the common-property problem will obtain rights over them. INSURANCE : AN ALTERNATIVE EXPLANATION

A common belief among economists is that insurance is a tool primarily used to diversify risk. For example, in the case of fire insurance, it is assumed that 8

Perhaps this is why, though they meet the description of large equipment, they are never used to illustrate the neoclassical firm.

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building owners are risk-averse and purchase insurance to shift the financial risk of fire to those more willing to assume such a risk. This explanation is problematic given that large diversified firms that could easily self-insure often purchase fire insurance from smaller, less diversified, firms. It is also problematic to assume risk aversion in corporate contexts. If we assume risk neutrality, then the building owner’s objective is to minimize the expected loss of fire. The property rights approach shows that something like fire insurance is better thought of as a form of assigning ownership over a specific attribute of the building: the fire risk attribute. Not being a fire-prevention expert, an office-building owner would like to secure the services of someone capable of minimizing the expected loss from fire. The specialist could be hired for a fixed wage; however, the building owner lacks the proper knowledge of fire protection to direct the employee to do the right job. Under a fixed wage, the employee would also find it easy to shirk and would have no strong incentive to ensure that the fire-prevention program is effective, let alone efficient. Indeed, to the extent the employee has specialized knowledge on fire protection, he might be unwilling to reveal it to his employer while receiving a fixed wage. It is possible to overcome this difficulty by making the specialist responsible for his own actions. The specialist who charges a fixed fee for his services, while assuming residual claimancy, provides fire insurance at a fixed premium, presumably competitively determined.9 As an insurer, the specialist loses from a fire and gains from its absence. He is, therefore, motivated to take preventative actions to reduce fire hazards: installing proper fire detection devices, conducting fire drills, and enhancing speedy fire fighting when fire does occur, in order to reduce the net expected cost of fire losses. The insurer is thus one of the part owners of the building: he owns the fire occurrence attribute of the building. Because the expected value of such ownership is negative, the insurer makes a negative payment; that is, he receives a premium in order to acquire the right to the fire-occurrence attribute. This analysis constitutes the application of a general principle. Specialists, by definition, know more about their line of business than do their customers. They are therefore in a position to charge a high quality price for low quality service and not be detected. For this reason, people are reluctant to deal with them without a service guarantee. Insurance may be viewed as one form of the sale of guaranteed service, which amounts to a division of the ownership of the insured assets between the nominal owners and the insurers themselves. Fire insurance is seldom all-encompassing. Full insurance coverage implies that the insurer is the sole residual claimant of the fire hazard facing the insured

9

The need for capital to guarantee the actions promise of the insurance specialist will be discussed below.

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firm.10 It is unlikely, however, that only the insurer influences the incidence and loss of fire; the insured also affects fire losses. The latter usually has control over (i.e., he is the low cost provider of ) day-to-day decisions about where and how flammable materials are stored, whether or not smoking is discouraged, and how well its employees keep fire escapes unobstructed. Both parties, then, contribute to the mean effect of fire hazard, and both are expected to bear some of the effect. Consequently, coverage is not full and both the insured and the insurer become, to varying degrees, residual claimants of the fire hazard. Two refutable implications could test the hypothesized role of insurance. First, when a party’s contribution to the mean loss of fire decreases, the fireinsurance contract will be modified to decrease that party’s share of the fire losses. For instance, suppose that motors are used in the insured operations. A switch by the insured – due, say, to a change in relative fuel prices – from gasoline motors, which are a serious fire hazard, to electric motors, which are less of a fire hazard, constitutes a reduction in the insured’s contribution to fire hazard. Besides the reduction in total insurance payments, the insured’s share of the income variability due to fire hazard ought to be reduced; in this case the coinsurance rate should be lowered.11 Second, consider a distinct pattern of attribute ownership between two types of condominiums. In the first all the units are located in one building, whereas in the second the individual units consist of separate structures. Fire and plumbing problems in one unit are more likely to spill over to other units in the single building than among the separate structures. It is expected that in the single building the apartment owners will allocate the ownership of the effects of fire and plumbing problems to the management, whereas the individual owners will tend to own (and, if they so choose, to transact for) these attributes where units are in separate structures. The severity of the common-property problem encountered with complicated asset use varies from one asset to another, as well as across different attributes of the same asset. Divided ownership of the asset permits the separate handling of various common-property problems. Each problem can receive individual treatment, while areas from which the common-property problem is absent may entirely escape the treatment designed to cope with common-property issues. Isolating individual common-property problems through divided ownership is only one step toward solving such problems. 10 11

For coverage to be full, it must include, besides direct losses, such effects as those due to lost business, to inconvenience, and to suffering. Likewise, when a building is left vacant the chance of fire (and other hazards) increases due to the absence of the nominal owner. It is predicted that deductibles and insurance rates should increase; indeed, some types of hazards may no longer be insurable, making the nominal owner of the building the full owner of the hazard. Insurers indirectly perform another service: the policing of employee diligence in reducing expected fire losses. A relative increase in some premiums signals to owners that their employees have become too lax. For a related discussion, see Hall (1986).

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MITIGATIONS OF COMMON - PROPERTY PROBLEMS

Scale and Wage Contracts A simple way to contain the common-property problem is to scale down the size and value of the asset. If the asset is some form of equipment it may be possible to scale it down to fit a single operator. Now the capture problem disappears, the problem of raising capital is eased, and the need for organization is obviated. The sacrifice associated in economies of scale and the loss of potential specialization, however, is often too large to justify the scaling down.12 An example of the scaling down of equipment is provided by many of the tools designed for non-professionals. These are often low-cost, low-quality versions of superior professional-quality tools. Professionals are willing to pay the higher prices because they use the tools more intensively. Thus, lawn tractors used by professional garden maintenance firms are larger, more powerful, and have more features than garden tractors sold to individual homeowners. If a rental market were to develop, non-professionals could then use tools designed for professionals. However, the common-property problem would then reappear, since individual users would have little incentive to handle the tools carefully. The problem seems severe enough that amateurs often prefer to be the sole owners of low-quality tools rather than share the use of high-quality ones.13 Another method of containing capture costs is to alter the contract of some of the parties. The wage contract constitutes a major application of this method. By rewarding the worker for their time, that contract abates the excessive use of assets like large-scale equipment. This is an implicit result of the argument put forth in Chapter 6 on contracts, where it was noted that nutrients are a free attribute to fixed-rent tenants, who are expected to extract them in higher quantities than would a self-employed owner. Nutrients may be a free attribute to fixed-wage workers as well, but since such workers do not gain from extracting the nutrients, they have no incentive to extract an excessive amount of them. Similarly, fixed-wage workers who share large-scale equipment do not expect to gain from exploiting it, and so would tend not to overexploit it. If the wage contract was strictly an exchange of time for money, employees would simply provide time without ever lifting a finger as long as work effort did not directly generate utility. Although such employees would not purposely harm the equipment around them, neither would they do anything useful. If 12

13

The potential for multiple shifts is also sacrificed as long as the equipment is used by only one person. This potential is sometimes also sacrificed within firms, presumably to enhance employees accountability and thus ease averting the remaining common-property problems. They also enjoy quick access but forgo the opportunity to share the costs of storage and maintenance.

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they are induced to work, they may then be careless with large-scale assets and cause damage. It is obvious that the wage contract is more than an exchange of time for money; employers must be able to induce employees to perform various tasks at some minimal pace and care. This will require supervision, direction, and monitoring of wage workers. Were the exertions of workers and machines proportionate, employers could fully rely on worker maximization (i.e., doing as little as they can get away with) to avert the overuse of the equipment. Some substitution between the exertion of workers and machines, however, seems possible; at the very least, workers lack the incentive to service their equipment. Therefore, job specifications and supervision must take into account such opportunities and make provisions for equipment maintenance. Workers who sell their labor services by way of a wage contract are engaged in a constrained transaction: they agree to obey a certain range of instructions. These instructions are designed to induce the performance of productive services and to discourage workers from inflicting harm on equipment (or on fellow workers). In turn, employers also accept various constraints on their behavior, such as agreeing to a maximum or minimum equipment speed, providing coffee breaks, and permitting grievance procedures. These various property right restrictions are splits to the property rights held by the employer and the worker. That is, a wage contract means the property rights are incomplete for the worker and the employer. The actual split, or scope, of rights held by employers and employees defines the organization that manages the transaction cost problems of production. As noted, at some point, this scope of rights begins to resemble what we call a firm. Restrictions on Property Rights Economists are prone to considering any restriction, attenuation, or removal of an individual’s property rights to be undesirable. A person’s ability to realize the potential value of their property consists of the ability to use, exclude, alienate, and derive income from the property. The ability, or power, to exclude prevents the property from becoming common property, and the ability to alienate and to derive income permits the realization of gains from exchange.14 Since restrictions generally reduce freedom of action, restrictions on a person’s property rights might seem to reduce the value of the property to its owner. However, when restrictions on, or transfers of, one person’s rights increase the rights of another, the new distribution of incomplete rights may help to improve property rights strength across all of those involved in exchange and production and increase the joint value of everyone. Thus, there is often an incentive to voluntarily accept incomplete rights. 14

The terms of alienation – whether price discrimination is legally permitted, whether sale is subject to price control, and how easily buyers can collude when dealing with the seller – affect the value of the rights.

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As noted, when ownership of the commodity attributes is efficiently divided, effort is still required to exclude each divided owner from using attributes belonging to any of the others. One way to affect exclusion is to limit the property rights of some owners in a way that prevents attributes from becoming common property. Therefore, restrictions on ownership over some attributes can enhance the strength of exclusion. Such restrictions tend to prevent non-owners from consuming those attributes that belong to others. Refrigerator ownership is a straightforward, convenient example of the role of incomplete and divided ownership over attributes. The sale of refrigerators to final consumers does not constitute an outright transfer of all attributes, since the manufacturers remain the owners of the attributes that are subject to warranty and those for which they are liable.15 Manufacturers are more efficient owners than consumers of the potentially lethal leakage of the coolant because it is their actions during the manufacturing process that largely determine whether or not the coolant will escape. Manufacturers are also the more efficient owners of the longevity of the motors, which depends on procedures about which manufacturers are informed at a low cost and consumers are uninformed. Refrigerator buyers, then, become the owners of only a subset of refrigerator attributes. Given that the motor is subject to a warranty, they do not bear the entire cost of a motor’s short life; given liability, they do not acquire ownership of attributes such as “leakage of coolant.” The ownership of refrigerator attributes is divided between the manufacturers and the consumers. The advantage of divided ownership becomes evident when alienation is desirable. This is the case not only when a new refrigerator is transferred from manufacturer to wholesaler to retailer and ultimately to the consumer; it is also desirable when a used refrigerator is offered for sale. Consumers who decide to sell their refrigerators only transfer to buyers those attributes that they own. If they were the owners of the attribute “leakage of coolant,” they would encounter difficulties in arranging a sale, since it would be too costly for them to provide satisfactory information about that attribute. The manufacturers, on the other hand, who are the efficient owners of “leakage of coolant,” maintain ownership and liability for it. The consumer owners, therefore, are not involved with the transfer of the “leakage of coolant” attribute, and the sale of those remaining refrigerator attributes that are easier to alienate is correspondingly facilitated. The problem with this divided ownership is that access to attributes owned by others creates common property. Restrictions on consumer property rights can reduce this problem. For instance, refrigerator manufacturers retain ownership of liability and warranty attributes only if consumers submit 15

The manufacturers retain ownership of income streams that have only zero or negative values. They are the residual claimants, i.e., responsible for those negative income streams. Payments to the manufacturers for these potential services come ahead of time, when the original transactions are concluded.

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to restrictions on such things as abuse, tinkering with parts, and commercial use. Such restrictions remove property rights from the consumers and help to isolate the attributes owned by the manufacturers from encroachment by consumers. This lowers the costs of dissipation. The consumer’s incomplete ownership means that those who use their refrigerators commercially stand to lose the warranty protection. When a warranty is voided because the product is being used commercially, a consumer is being penalized for exercising a right they do not legally possess. The consumer does possess, for example, the right to decide what foods to store in the refrigerator. Indeed, because the restriction on commercial use reduces capture costs, it increases the net value of the original transaction; in other words, it increases the value of the remaining attributes that are owned by the consumer. Restrictions must be enforced in order to be effective; such enforcement is costly, but not uniformly so. For instance, commercial use of refrigerators can be easily proved; therefore, manufacturers make the warranty conditional on private use. Plain carelessness is too expensive to police, and careless behavior is not restrained. Conversely, the duration of the warranty is shortened when careless behavior is expensive to police – paint on refrigerators is guaranteed for a much shorter time than are motors. The distribution of property rights over a commodity vary in terms of who owns what set of attributes of that commodity, but also varies in terms of what property rights are possessed by any given owner of attributes. Property rights are often incomplete because the loss of a property right of one owner is often the gain of that property right to another. This transfer of rights, which appears as a restriction of rights to an outsider, enhances the overall value of ownership by mitigating the common property problem of divided attribute ownership. THE FIRM VERSUS THE MARKET: A FALSE DICHOTOMY

The neoclassical model of the firm is a model of production, not organization. In this theory of production, “the firm’s” sole purpose is to select the optimal bundle of inputs that maximize profits, based on a production function. It is a perfect information model of output based on technology, and input and output prices. In the neoclassical approach, where entrepreneurs possess perfect knowledge of market conditions, of all attributes of inputs, outputs, and the production function, the organization within the firm is innocuous. Any operation within the firm is, in essence, an exchange between the inputs that could just as easily have been performed in the market without recourse to such organizations. For instance, any worker may operate independently, remunerated strictly by the value of output (from which damage to equipment owned by others is netted); since the true value of any component of a worker’s contribution can be costlessly assessed, the worker can also be directly remunerated for it. There is no compelling reason for workers to become employees, rewarded

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indirectly by the hour. At the same time, there is no harm in employing workers by the hour, because under given conditions their hourly contribution can also be evaluated costlessly. But, as was previously stated, this equivalence between employees and independent workers is precisely what renders such organization innocuous. As such, the neoclassical model of production says nothing about what a firm actually is or why its ownership might take one form over another.16 Real firms not only produce outputs to sell, they use a host of inputs – including financial, accounting, personnel, marketing, and legal services – that are engaged in supervision and monitoring. Real firms are sometimes housed in a single location, sometimes in multiple plants, and other times multiple firms occupy the same physical space. Within firms, different types of owners cooperate and are paid in different ways, creating a network of residual claimants. Unlike the neoclassical firm, the entrepreneur does not own all of the nonlabor factors of production. Given that real firms exist in an environment of costly information, and that firms are made up of many individual owners of inputs, the supervision and management of these inputs becomes necessary. Coase (1937) likely was the first modern economist to consider the organizational role of the firm, and following the traditional approach he considered cooperation as taking place either “within the market” or “within the firm.” In neither case is the classification exhaustive, but the two types of cooperation are assumed to stand in sharp contrast to each other: Activities within firms, unlike activities in the market, require organization. Coase’s radical approach attempted to explain why some activities are guided by prices in the market, while others are guided by orders within the firm. He argued that market transactions involve the cost of discovering the appropriate prices, and that operating within firms, where the employer directs employees and restricts their actions, is a means of reducing these costs.17 Coase does not follow through fully on his assertion that market transactions are costly. In order to incorporate such costs into the analysis, a precise definition of the term “market transactions” must first be provided. Two distinct definitions of market transactions are seemingly consistent with the common understanding of the term. One is that they are properly and fully priced transactions and therefore free of distortions. In other words, in such transactions individual buyers and sellers bear the full costs of their actions. Whereas Coase does not explicitly suggest that market trades involve deadweight losses, the asserted costliness of such transactions implies that

16

17

Prominent critics of the neoclassical firm include Coase (1937), and decades later Alchian and Demsetz (1972), Williamson (1975), Jensen and Meckling (1976), Klein, Crawford, and Alchian (1978), Cheung (1983), Goldberg (1985), and Williamson (1985). Coase does not explain how employers acquire the knowledge underlying their orders. Since such knowledge must be based on prices, employers’ action does not obviate the need to discover prices.

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some tangency conditions of the zero transaction cost model are violated.18 This view of market transactions implied by Coase seems to be a correct view of reality. Indeed, we contend that the Pareto conditions for efficiency are always violated.19 But this means it is not useful to define market transactions as those free of distortion since, by this definition, markets do not exist. The other, not well-recognized, definition of market transactions is one where transactions leave no obligations between transactors; that is, these transactions are governed by caveat emptor. This definition is attractive for two reasons: the price alone determine buyer decisions; and it is a clear-cut practice. However, generally caveat emptor transactions are too costly and therefore govern only a small fraction of the total volume of trade, and only under narrowly circumscribed conditions. Would-be buyers of a commodity subject to caveat emptor either inspect the commodity sufficiently to convince themselves that they are not throwing their money away or, satisfy themselves of the seller’s reputation, which requires the seller to have previously invested in that reputation.20 The within-firms transactions, then, are not unique in imposing restraints on the participants. Market transactions, defined this way, are also subject to restrictions. The question is not whether to have restrictions or not, it is what form of restrictions maximize the value of exchange. Cheung (1983) makes a similar point. Although he considered the term “firm” to be poorly specified and not operational, he retained the distinction between “firm transactions” and “market transactions.” He said that the “ ‘firm’ is ... a way to organize activities under contractual arrangements that differ from those of ordinary product markets” (p. 3). Given positive transaction costs, organizing activities in the product market – at least non-caveat emptor transactions – requires imposing restrictions on the transactors, restrictions that are of the same character as those in the firm. The dichotomous distinction that Coase proposed is starting to disappear. In most transactions, particularly those which are highly valued, seller obligations continue after the sale is completed. This is the case when sellers guarantee sales and when they become liable for product malfunction. Indeed, these two obligations often apply simultaneously, highlighting the fact that 18

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20

Note that because of the costs of conducting market exchanges, the net amount the seller receives is less than the total amount spent by the buyer; money prices presumably are either those buyers pay, or those sellers receive, and in both cases they then convey only partial information about the terms of exchange. The view that, aside from occasional “externalities,” markets are free of distortion is pervasive. This view is at the root of all sorts of confusion, especially when particular distortions are considered to be exceptions and therefore a call for exceptional measures, whereas in reality they are instances of the general case. A transaction solely guaranteed by reputation is not a pure, instantaneous market transaction, since the other side of such a transaction is the future retaliation against the owner of the reputation.

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different attributes of a transaction are subject to distinct problems and are differently constrained. These obligations are parts of market contracts that specify what each of the parties agrees to cede to the other. Contracts may also restrain the parties in order to enhance their ability to meet those contract obligations that are not discharged at transaction time. The use of constraints necessarily means that price is not the sole means of allocating resources. Implementing and policing market constraints requires an organization, and different kinds of constraints require correspondingly different organizations. Cheung’s suggestion that we study the contracts governing what are considered to be firm operations should be extended to include all constrained operations, whether they are “in the firm” or “in the market” since that distinction is almost meaningless. The employment contract, wherein a wage worker agrees to be ordered by his or her employer, is the one Coase singled out as characterizing the firm. This contract, however, is just one of an array of methods of constraining transactions within a firm. The discussion of the tenancy contract in Chapter 6 showed why the share contract and the fixed-rent contract are no more “in the market” than is the wage contract, even though only the latter is said to identify a firm’s operations. Many other contracts do not fall neatly within any single category. Consider the services one secures from an automobile mechanic, a doctor, or a plumber. Contracts for such services take at least two basic forms. One is to charge by units of output: flushing a radiator, treating a sprain, or fixing a leak. Supposedly, charging on this basis places the transaction in the market, even though each service provider may guarantee their service. The other is to charge based on time, which presumably is a type of employment contract. The service provider becomes an employee within “a firm” and follows direction, albeit for a very short time. Pigeonholing transactions as being “in the market” or “within the firm” is not very illuminating since there is a continuing relationship in both cases. The choice between the two types of contracts is a matter of information and concomitant transaction cots. How do the parties secure information about the quality of the services provided? Securing the information requires measurement of the service provided, or when it is too expensive, the measurement of the effort of the provider as a proxy of the measurement of the output. Exchange is a process that alters the distribution of property rights through the cession of some rights to different individuals within the context of a given situation. Therefore, different types of contracts (distributions) may be expected to be employed in different situations. It would be even more instructive to determine what characterizes contracts that belong in firms where individual workers concede to their employers control over time, and proceed to analyze the structure of firms.

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CURRENT THEORIES OF THE FIRM

Alongside Coase’s (1937) groundbreaking contribution, the economics literature offers two additional prominent transaction cost-based explanations for the existence of firms. One is by Alchian and Demsetz; the other is by Williamson and by Klein, Crawford, and Alchian. More recent transaction cost-based insights are offered by several authors. Among these are Grossman and Hart, Hart and Moore, Holmstrom and Milgrom, and Milgrom and Roberts. As stated, Coase viewed the firm as a means to economize on the use of prices. The efficient collaboration of resource owners through the market requires the determination of the prices of factors and of intermediate products at which the parties would exchange. Such determination is costly. Coase argued that organizing production within firms, where the employer instructs the employee over what to do, saves on these costs. Since direction within a firm generates its own costs, a boundary exists where market transactions leave off and the firm begins. Alchian and Demsetz (1972) hypothesized that the firm is a means to realize the economies of “team production,” and that members of the team are bound to the firm by a nexus of contracts. In team production, measuring the output of one member cannot be separated from that of others, but measuring the effort of team members is an adequate proxy and is observable. When the inputs are used within a firm, the firm includes an effort supervisor. This supervisor ensures the fixed-wage employees are working and, because no one can supervise the supervisor, he receives the residual as his reward and self polices. The residual claimant-supervisor is then at the center of the firm and has the incentive to maximize the value of the team’s output. This approach to the firm is based on measurement, but only in a specific way. In the Alchian and Demsetz model the output of team members cannot be separated; it is assumed the measurement of the individual workers is always prohibitively expensive. In general, however, whereas measuring individual output is always costly, this cost varies from one case to another, and individual worker effort may sometimes be measured. Recognizing the variation in the cost of measuring marginal products has the advantage of determining whether an individual contribution will be restricted in a way that resembles “a market” transaction or “a firm” organization on a case-by-case basis. Any changes in measurement costs may alter that determination. Both Williamson (1975) and Klein, Crawford, and Alchian (1978) suggested that efficient production may require specialized, sunk inputs. If such inputs are owned by different individuals, then the parties may be able to capture each other’s specific investments through ex post bargaining. They argued that firms tend to integrate vertically to avoid rent capture brought about by the sunk investment. Vertical integration eliminates the deadweight loss associated

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with ex post bargaining and increases the size of the firm. Barzel (1982) offered a distinct reason for vertical integration: intermediate outputs that are costly to measure may be captured when their ownership is transferred. Therefore, firms that produce such intermediate outputs are likely to integrate upstream to avoid the capture losses. Such difficulties seem to be common, so most firms internally perform several vertically related tasks. Here too a change in the cost of measurement may alter the decision whether to place more or fewer restrictions on tasks in such a way they resemble firm or market production. Grossman and Hart (1986) and Hart and Moore (1990), despite including what they consider as “property rights” in their approach, ultimately have a model of the firm based on complementary assets. Here, owners have an incentive to invest in their assets and are able to exclude non-owners from the use of this asset. This threat is used in negotiations over the return to the asset, and influences the incentive to invest prior to negotiation. Each party then owns the asset for which their investment is the most important. Common ownership results when there are substantial complementaries in investment returns. Milgrom and his associates approach the complexity of the incentive structure from a different angle. Both Milgrom and Roberts (1990) and Holmstrom and Milgrom (1994) emphasize the multidimensionality of tasks performed by workers and the corresponding need for coordinated incentives and constraints when the workers operate as employees. These various theories focus on particular instances of transaction cost problems, often within the context of very specific types of models. As such none of them satisfactorily account for the general scope or boundaries of the firm. There appears to be no empirical work to demonstrate that the size and structure of actual firms conform to these models. Casual empiricism does not provide support for the notion that these are the main reasons behind the existence of actual firms. For instance, it is difficult to see how the size and structure of both Safeway and the corner grocery store can be attributed to forming prices, team production, specific capital, the measurement of intermediate output, or task multidimensionality. However, an explanation of both the size and the scope of the firm follows from a remark we made earlier: residual claimants must be able to absorb large negative residuals. In order to do this, owners must have large amounts of equity capital which can play this guarantee function, subject to a scale economy. This function then provides a means of defining the boundaries of the firm. Guarantee problems arise only where variability is present and large negative shocks are possible. The allocation of variability must be discussed before the guarantee function can be tied to the firm. THE ALLOCATION OF VARIABILITY AND THE RESIDUAL CLAIMANT

As noted in Part I, variability is a necessary condition for transaction costs, and therefore the economic role of property rights. Variability can always be eliminated; it can be explicitly priced, it can be taken care of by sorting commodities

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into homogeneous groups, or through some other means. But each of these comes at a cost, and variability and its consequences always remain present. It is conventionally asserted that employers pay wages to employees to insulate workers from the effects of variability: employees receive fixed wages and employers bear the entire variability in firm operations. The term “wage contract,” however, is not a single arrangement: Workers may be hired daily and paid a spot wage, they may be hired for life for a fixed sum, or they may be hired on some intermediate basis. In addition, the employment contract may contain such features as escalation clauses, inflation adjustments, schemes for severance payments, specific pension plans, and requirements for advance notice of layoffs. The “fixed wage” employees receive is not truly fixed either per unit of output or per unit of time. Each contract type exposes workers to a different variability compared to the other contracts. Employers are likewise subject to a variability that depends on the particular contract chosen, because they are exposed to the complementary or remaining variability.21 The considerations that apply to labor also apply to both the prices and the quantities of all other purchases and sales. Regarding variability in quantities, firms may purchase their trucks and then bear the effects of varying durabilities across trucks, or they may rent the trucks, shifting the variability in longevity to rental agents. In the same fashion, employers who pay uniform hourly wages to nonuniform workers bear the variability in performance among the workers, whereas workers who are paid by the piece bear more of the variability in their own performance. As a final example, buyers bear the effects of variability in product quality for purchases subject to caveat emptor; if the purchase is not governed by caveat emptor, sellers bear at least some of that variability. Different distributions of property rights determine where the variability falls. If the function of ownership is to assign variability in order to increase joint income, then holders of corporate equity, who are usually passive participants in the operations of their firms, are not expected to become the residual claimants to the systematic component of the variability in the operation of a firm. Rather, an array of other transactors who can influence the outcome are expected to assume the effects of this variability. Fire insurers are expected to become the primary residual claimants of the effects of fire; the wholesale supplier of a commodity is expected to sign a long-term, fixed-price contract that guarantees the constancy of the price of their commodity and thus become the residual claimant to fluctuations in that price, and the buyer of bad debts is expected to become the bearer of the variability in the repayment rate. Each resource owner who transacts with a firm is expected to become at least a partial owner of the line of activities they control.22 Thus, a salesperson 21 22

Each contract will induce a different performance. The total variability also depends on the contract chosen. This implies that the all-or-nothing distinction over the separation of “ownership and control” as articulated by Berle and Means (1932) and exploited in studies of corporations, is too simplistic.

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rewarded by commission is more of an owner of their operation than is one who is paid a fixed wage. An in-house lawyer is less an owner of the outcome of legal action than is an outside lawyer paid by the hour, who is, in turn, less an owner of the variability in outcome than is the lawyer operating on contingency. Furthermore, in the case of legal services, the more a lawyer affects the outcome, the greater is that person’s expected share in outcome variability. Thus, a dispute about money between a firm and a party it deals with that depends primarily on a legal argument is expected to be handled by an outside lawyer on a contingency fee basis, not by the firm’s own in-house counsel. The preceding illustrations of the allocation of variability faced by individuals within “the firm” share a common thread. Each party dealing with the firm that affects the outcome collaboration is expected to assume some or all of the associated variability. Moreover, to the extent that a party transacting with a firm affects the product it produces, it is also expected to guarantee the outcome to the buyers of the product. But what if an individual cannot bear all of the variability that is optimally assigned to him? ASSUMING VARIABILITY AND THE ROLE OF EQUITY CAPITAL

When a negative shock arises the levels of transactor wealth constrains the ability to meet contract obligations. For instance, the wage promised to a worker may diverge at any time from the alternative market wage of that worker. When the wage falls short, the workers implicitly agree to finance the difference; when the wage exceeds the contribution, the firm must agree and be able to finance the difference. The parties, then, must have the means to make good on the guarantees, and people differ in that ability. Because these problems seem most crucial in the exchange of labor services, consider an illustration from the practice of contracting for labor service. It might be advantageous for workers to become the residual claimants when their actions impose a high cost on others. For example, if the product they produce is subject to liability problems, if they damage valuable equipment, or if they could harm others with power tools. The value of the associated variability, however, might be larger than workers are able to guarantee. As a rule, workers are severely restricted in their insuring ability, particularly since agreeing to use the value of their future labor services as a lien is not legally enforceable – doing so would constitute voluntary slavery. Therefore, although the potential gain from guaranteeing their actions may be large, many workers often do not have the wherewithal to do so. This dearth of guarantee capital can be rectified through trade between the workers without such capital and individuals who possess it. However, capital owners will only assume the guaranteeing role if they can also constrain the workers to curtail liability problems, damage to equipment, or injuries to fellow workers. Otherwise the guarantee function cannot be profitable. Here, again the wage contract and accompanying supervision may be used.

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The capital involved in such a guarantee is “equity” capital, and the firm can be defined by level and extent of its guarantee capital. The extent of the firm comprises the set of contracts whose variability is contractually guaranteed by common equity capital. The firm, then, is a nexus of outcome guarantees. This definition is operational because it is possible to determine when a firm’s equity capital has increased or shrunk and therefore predict when the firm will expand its operations, and what its debt-equity ratio will be. Consider a publishing firm. If it commissions a writer to create a manual paying him a lump sum, then all the variability from sales of the manual rest within the firm. If, however, it signs a pure royalty contract with the author, only part of the transaction is in the firm, since the author bears a share of the variability in the sale of the book. Assuming that the latter venture succeeds, and that the publisher proceeds to publish more of the writer’s work, then the new contract will gravitate toward a higher (nonrefundable) advance and a smaller royalty rate, placing it more within the firm. This is because the author’s work becomes more predictable with experience; correspondingly, the publisher is better induced to advertise the book if the marginal payments to the writer are smaller. Of course, the publisher has many other contracts. Fixed-wage contracts with employees are mostly in the firm, while contracts with salespeople who work on commission are less so. The latter are likely to be even less within the publishing firm when used for sales abroad, where the publisher’s expertise relative to that of the salespeople is less than for domestic sales. Publishers’ contracts with bookstores may stipulate the outright sale of the books or, alternatively, a buyback of the unsold copies. In the latter case, the transaction partially remains within the publishing firm, since it bears part of the risk of poor sales and, of course, the publisher must have the means for the buyback.23 Finally, if the publisher chooses to expand into an experimental line of publishing, the debt equity ratio is expected to be reduced, since the chance of large losses increases. Although owners of labor cannot guarantee large potential losses, they can readily finance one particular obligation – to supply labor services when the market wage exceeds the contract wage – simply by showing up for work.24 Owners of labor are, therefore, more likely to enter into contracts in which they are required to guarantee the difference between their market wage and their actual wage than they are to enter into contracts that require them to guarantee other possible effects of their behavior. The inability to personally guarantee large losses applies to many professionals, including lawyers. For this reason, one expects only large law firms to undertake large contingency cases requiring a substantial amount of legal services without the guarantee 23 24

The publisher demonstrates such an ability by simply selling on credit, which might explain why wholesalers often sell to retailers on credit. In other words, workers simply continue to work at the contract wage, and the difference between that wage and the market wage accrues to their employers.

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of reward in particular cases. Small law firms may be unable to finance the up-front legal services required in such cases. Equity capital is the factor that specializes in guarantees. The more equity capital an individual provides, the higher the contract value that can be guaranteed. For instance, certain types of workers may be most productive if provided with substantial on-the-job training. Workers may be reluctant to pay for the training unless their future remuneration is guaranteed. The firm’s equity capital must be sufficient to provide such a guarantee for its employees; ceteris paribus, the higher the outstanding equity capital, the more likely a larger level of training is optimal. Equity capital is productive, and its amount will be expanded to the point at which the cost of expanding it by one more unit brings an equally valued improvement in contract terms of the employed factors, including borrowed capital. The guaranteeing function, therefore, determines (at least in part) the optimal level of equity capital. The use of equity capital to guarantee the firm’s activities is subject to both economies and diseconomies of scale. These scale factors play a major role in determining firm size. The scale economies arise from the fact that specific variable outcomes are random, and therefore the capital that “stands by” to guarantee one prospect can be used to guarantee others, though with declining probability. Put somewhat differently, providing a given guarantee level to a larger volume of prospects requires a less than proportionate increase in the amount of guarantee capital as long as the prospects are not perfectly correlated. This factor, then, favors large-scale firms. Guarantee capital is not capital itself but the command over it. When a guaranteed payment is made, the capital is transferred from its current owner to the beneficiary of the guarantee. The ease of transfer is important, but it is costly as well. The guarantor who holds enough cash to be able to insure the guarantee loses the return that the asset would have provided, but it can more readily be used to make guarantee payments. On the other hand, the guarantor who holds physical capital will incur a cost of transfer when creating a guarantee; as the size of the payment increases, the cost rises per dollar of transfer, since the assets that must be used for the transfer are progressively less liquid. Although the guarantor is assumed to be risk-neutral, because of this liquidity problem the guarantor will appear to act as if risk-averse. Diseconomies of scale to guarantee capital arise when different individuals take part in assembling it. If individuals simply guarantee each other’s prospects without constraint, then the partners’ incentive for caution is weakened. They may pool their capital, as is done in stock corporations, thereby resolving that free-ride problem. But when individual shares are small, ownership and control tend to diverge. In either case, this problem limits the size of the equity capital and, consequently, firm size. One final point worth mentioning is that the role of equity capital may be usefully contrasted with that of the share contract. The equity firm uses

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its equity capital to guarantee its contracts with resource owners who sell their services to it (and the quality of its product). Under the share contract, the cooperating resource owners simply divide whatever the outcome of their efforts turns out to be, thereby eliminating the problem of guaranteeing factor remuneration. Sharing is likely to emerge when the provision of guarantees among factors is difficult (as is the case when the cooperating factors consist mostly of workers) and when their output is easy to divide. The contingency contract is a form of sharing common in legal work. Under this contract no guarantee capital is needed, but the supplier of legal services must be able to self-finance the legal work since remuneration is not guaranteed. AN ILLUSTRATION : CUSTOM COMBINING

In Chapter 6 on contracts, we examined the common land leasing arrangements between farmers and landowners. Farmers enter into many other types of contracts, including those for heavy equipment. Alternatively, farmers can own large scale equipment and either share it with other farmers, or hire wage workers to exploit the equipment on their lands as well as on neighboring farms. In other words, the organization of the farm can extend or retreat over various margins of production. Innovations in harvesting equipment proves an example of how changes in transaction cost conditions determine the extent of the farm. One of the most valuable pieces of equipment for farming crops is “the combine.” A combine is a self propelled machine that cuts the grain in the field, draws the stock and grain into the machine where they are separated, and then drops the grain in a bin and blows the straw and chaff out the back onto the field. Once the combine bin is full the grain is transferred to a truck and hauled away. The machine is a marvel to behold, and gets its name from the fact that it literally “combined” the tasks of dozens of men, horses, steam engines, and thrashing machines that were used to harvest the grain prior to the mid-twentieth century. A combine has two interesting features for our consideration. First, it is relatively expensive and can easily cost between $250,000 and $500,000. Second, the harvest season is short, often lasting only one week of the year for grains like wheat, oats, or canola. Other things equal, one might predict that farmers would rent combines, with restrictions placed on the use of the machine. Interestingly, combines are sometimes rented along with the machine owner, but more often than not they are owned by individual farmers. As discussed in this chapter, both sole ownership and contracting have costs in terms of lost gains from specialization, common property problems, misuse of unpriced attributes, and inability to guarantee payments in all variable circumstances. Depending on the circumstances, one type of ownership pattern, or distribution of rights, emerges as optimal.25 25

See Allen and Lueck (2005) for a discussion of custom combining.

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The most important factor in the harvest of grains with a combine is the timing. In order for the combine to work the grain must be ripe so that it is brittle enough to separate from the stock and fall into the bin. In North America, in the northern parts of the Great Plains, harvest times are from late summer into the fall. This means that the risk of heavy rain or snow increases with waiting, and a delay of even a week can mean the loss of an entire crop. This poses a large risk for the farmer in renting a combine because it might not be available the moment he wants it. Contracts that might insure against these losses are not feasible given the large role of Nature in the harvest. Dozens of things, from weather to field conditions, increase the measurement costs of knowing whether a combine owner was late on arrival for things in or out of his control. Thus, despite the large cost and low utilization rate, farmers have tended to own these large machines. Since combines come in multiple sizes, farmers are able to choose the size of machine to suit the size of their farm.26 An interesting feature of grain harvesting in North America is that going from south to north, the Great Plains are contiguous in terms of their climate. The harvest in the south can start in late spring and early summer, and continue into the fall as one moves north. This means that a combine owner can move from the south to the north and harvest for almost half of the year, allowing for large gains in specialization and scale economies in terms of combine size. Improvements in roads, communication, and weather forecasts have allowed these private combining firms to increasingly compete with solely owned private combines.27 Most interesting is the fact that when combines are rented the farmers do not simply rent the machines. Rather the practice is known as “custom combining” where the owner of the combine harvests the field for the farmer; that is, the machine is rented with the owner-operator. The combine, being a complicated machine with multiple attributes, is greatly subject to abuse by a renter. As a result, the combine owner either operates it directly, or when he owns more than one machine, he hires wage employees to operate the other machines. Thus custom combining provides an example of the tradeoffs between specialization gains and the transaction cost of particular types of ownership. The benefit from custom combining comes from the intensive use of highly-specialized equipment with skilled operators. However, this can 26

27

Threshing machines were used prior to the combine. At that time, the grain was cut and stacked independent of the threshing. This removed the timing problem and farmers were able to contract with custom threshing companies. Over the past twenty years farmers in the Northern regions have started to kill their grain crops a week or two prior to harvest by spraying Glyphosate, the main ingredient in Monsanto’s Roundup herbicide, on their fields. Known as “desiccation,” the practice drys the grain while it is still standing in the field and allows for an earlier harvest. The earlier harvest reduces the risk of negative weather shocks. Predictably, custom combining has increased with desiccation.

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only be exploited if the costs of reliable arrival can be achieved. Modern communication and weather forecasting has allowed for the reduction in the effects of natural variability, and this has allowed, in many instances, for combines to move from within the control of family farmers to being exchanged across custom combine market transactions with restrictions. CONCLUSION

Commodities and productive inputs have many different attributes, and the value of these commodities is not necessarily maximized if they are all owned by single individuals; value may be enhanced by allocating ownership over individual attributes according to comparative advantage. This comparative advantage depends not just on the usual abilities to produce, but also on the ability to mitigate the transaction cost losses that arise from exploiting free attributes. Some assets are large-scale, and more likely to benefit from multiple users. In such a case, however, the attributes will be subject to common-property problems. One method to mitigate this problem is to constrain the users through the use of a wage contract. Wage workers are rewarded for their time, and lack the incentive to overuse the free attributes of large-scale assets. But wage workers also require direction and organization, and this organization might begin to resemble what we normally think of as the firm. This may explain the dominant use of time as the unit by which so much employment is paid, and why wage workers are often identified through an association with a firm. There are other methods of mitigating the transaction costs of common property. Other constraints may be used, and these may be used across what we think of as market transactions or within a firm. The mere absence or presence of a constraint does not generate a clear distinction between operations in the market and in firms. Firms are characterized by specific types of constraints and relations that result from positive transaction costs. For this reason, the standard neoclassical model of the firm is a model of production, not organization. Most critically, in our model, a firm is organized around how to allocate the variable outcomes that result from cooperation among the various productive inputs. This allocation is driven by the principle that the greater the inclination of a productive factor to affect the mean outcome, the greater the claim on the residual that that input owner will assume. Most activities are subject to many sources of outcome variability, and different resource owners or sets of owners may assume different parts of the variability. Guarantees are required in the presence of variability. Not all resource owners possess the requisite amount of capital to guarantee their actions. This acts as a constraint on what input owners are capable of assuming the guarantee role, and this is especially true for those whose main asset is human capital.

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As a result, the owners of equity capital cooperate with capital-poor owners. The former guarantee the contracts of the various other resource owners within a single organization and may be viewed as the owners of the corresponding firm. Equity capital is subject to both economies and to diseconomies of scale, and these help determine the size of the firm; the more prominent is the former, the larger the expected size of the firm.

8 Institutions

INTRODUCTION

Over the past thirty years, the concept of an “institution” as an important (perhaps the most important) element in the creation of wealth has reemerged in economics after a long hiatus. Although modern work has little resemblance to that of Veblen, Commons, or the other original institutionalists, in the late 1980s, a new field of “New Institutional Economics” (NIE) emerged that synthesized the neoclassical framework and positive transaction costs with the aim of understanding “institutions.”1 The popularity of the concept and term partly stems from North’s 1990 influential book and a series of works based on it that generally found power in its ideas. These works included La Porta et al. (2008) on consequences of original legal systems; Acemoglu, Johnson, and Robinson (2001, 2002, 2005a, 2005b) on institutions and economic growth; Nathan Nunn and coauthors on institutional path dependence and long run economic consequences;2 and subsequent work by North and coauthors on institutional forms and the emergence of the modern world.3 The large empirical literature on “institutions” continually finds that they are a critical factor explaining the divergence in economic performance across countries.4 Whereas the economic literature on “institutions” is voluminous,5 our attention is focused on utilizing the theory of economic property rights to (i) clarify the definition of an institution, (ii) understand the boundaries of an 1

2 3 4 5

There is a field journal of institutional economics, and a search of economic journal titles shows almost 12,000 titles with the word “Institutions” since 1990. The previous 100 years had less than 1,000. See Ménard and Shirley (2014) for a history of New Institutional Economics and particularly the role Douglass North played in its development. See for example, Nunn (2008), Nunn and Wantchekon (2011), or Nunn et al. (2017). Most notably, North, Wallis, and Weingast (2009). See the Baland et al. (2020) Handbook for a collection of essays on the role of institutions on development. For those interested, something close to a survey is found in Ménard and Shirley (2005), which provides a Handbook treatment of the field.

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institution, and (iii) explain how they influence wealth creation. Our definition focuses on the relationship between institutions and the economic property rights of individuals who take the institution as exogenous. By explicitly recognizing the functional link between institutions and economic property rights the channel by which institutions are beneficial becomes apparent, since (as we have argued) resource allocation ultimately depends on individual economic property rights. By defining institutions in terms of economic property rights, we can also broadly explain why they evolve and vary over time and space. The components of an institution, we will argue, are themselves distributions of economic property rights and therefore are endogenous to the economic system in which they operate. This makes them subject to the economic theory of property rights, and therefore, we contend that an institution’s purpose is to direct and constrain individual behavior in a way that maximizes joint wealth net of transaction costs.6 Institutions can be broad to narrow, applying to either all of a particular society or just some subset, depending on the social transaction cost problem they are mitigating. A particular institution (e.g., a capital market) might be similar across societies but vary in its success because of the specific transaction cost environment in each different time or place. In some instances institutions might be highly successful and generate a prosperous and regenerative society. In other cases, they may fail to produce the desired behavior. Social stagnation that lasts for some time is common, and whether better institutions are even possible in a given circumstance depends on many transaction cost factors.7 As we will see, institutions are necessarily complicated systems, and there is no single means by which they strengthen individual economic property rights. An institution may have a comparative advantage in dealing with matters of social coordination, of third-party enforcement, of social goals, or of “regularities of behavior.” An institution’s comparative advantage may sometimes stem from a scale economy: when a wide range of individuals and organizations all require the same kind of specific mechanism for reducing a specific type of transaction cost, then a single institution may be able to efficiently supply it for all.8 Thus institutions arise when alternative private organizations are too costly to resolve particular types of transaction cost problems. 6

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Institutions have this in common with organizations and other distributions of property rights, although how institutions are created and deployed is likely much more complicated. For detailed treatments on how this might be achieved see, for example, Avner Greif (2005), North, Wallis, and Weingast (2009), or Acemoglu and Robinson (2019). Acemoglu and Robinson (2019) argue that there is a “narrow corridor” in which only a few societies have found and maintained to supply both sufficient state capacity to create credible legal property rights without falling into tyranny. They argue this is possible only when the state can be kept in check by a strong society and that this balance can be maintained over time, even as conditions change. According to them, many societies find themselves in circumstances that simply prevent an arrival into this corridor: They remain stateless societies or despotic regimes. This points to the difference between organizations and institutions. As noted in Chapter 7, an organization is a distribution of property rights designed by those involved in a specific type of

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PROPERTY RIGHTS AND INSTITUTIONS

Defining an Institution We have argued that economic property rights are the fundamental unit of economic analysis, and that economic property rights are the individual’s ability to exercise choice. Therefore, if institutions are to have any effect on resource allocation they must operate through, and can only be understood in terms of, economic property rights.9 Recall from Chapter 2 that an individual’s ability to make choices depends in part on the set of legal and natural rights faced by him or her. Individual property rights will also depend on other constraints like community standards, customs, moral values, and social norms (for the sake of brevity, we will refer to all these informal constraints as “social norms”). In Chapters 6 and 7, we argued that an individual’s property rights also depend on the contracts and organizations that the individual is involved in since these act to restrict and divide ownership. Again, for the sake of brevity, we will call these “private orderings.” This means there is a functional relationship between a person’s economic property rights and all of these concepts. We can express this as: Economic PR = f [(Legal PR, Natural PR, Social Norms), Private Orderings, x], where x is a vector of still other factors that affect economic rights. From the individual’s perspective, private orderings are under their control and not institutions. However, the legal rights, natural rights, and social norms are exogenous to the individual, and we define this collection or system as an institution. Institution: A particular system of legal rights, natural rights, and social norms that alter an individual’s economic property rights.

There are, in any economy, many institutions made up of various combinations of legal/natural rights and social norms. This definition encompasses all of them, from narrow institutions like “public education” or “aristocracy” to broad ones like “democracy” or “marriage.” Our emphasis is not on what particular combination of rights and norms make up an institution (which is widely discussed in the literature) but on the link between an institution and the individual’s economic property right.10

9

10

production. The form of the organization is endogenous to the owners of the organization. An institution provides exogenous constraints on individual economic property rights, even those within different organizations. Note the direction of causality. When property rights are primarily thought of in terms of legal rights, it is natural to think of economic property rights as a minor caveat for when some form of trespass takes place. Therefore, the logic would be that economic rights can only be understood through institutions. This is incorrect; economic rights can exist without institutions, but the reverse is not true. This link is embedded in much of the literature. For example, see Boettke and Fink (2011) who note that “institutions structure incentives and affect the mechanism employed to transmit information.” Or Congost et al. (2016, p. 182) who make a similar connection when they

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That is, institutions are made up of some combination of the formal legal systems and laws and the formal and informal natural laws and social norms that govern social interactions through their effect on economic property rights.11 In order for “institution” to have a distinct and useful conceptual meaning, it must include broadly understood natural rights along with the social norms that allow legal rules to operate.12 When a system of legal rules is only nominal, ineffective, not ever enforced, and unrecognized by society, then we would claim no institution exists even though explicit rules exist. On the other hand, when the legal rules interact with social systems that make up natural rights and social norms, an institution does exist. Institutions and Organizations Because institutions are made up of combinations of legal rights and social norms, they are outside the control of any given individual. Individuals take institutions as exogenous. This fundamentally distinguishes an institution from an organization or a contract. Contracts arise out of relatively small groups of individuals attempting to mitigate the transaction costs that result from their interactions and cooperation. Organizations are more complicated forms to attain similar mitigation. Those who are involved in creating contracts and organizations do not understand them to be exogenous. Thus, a faculty club, law firm, church on the corner, land lease, or the Declaration of Independence are not institutions. They are examples of organizations, contracts, and legislation. Institutions necessarily transcend given organizations and contracts even though they may contain them. Since institutions mitigate transaction costs, they generally operate in a fashion similar to organizations. They alter the distribution of economic property rights in many ways by regulating what can be owned and in what

11

12

write that institutions require “social appropriation” meaning that people must “make institutions ‘their own’ ... to legitimately appropriate resources, to constrain the actions of others concerning those resources, and conversely to resist being constrained by others.” This definition provides some context for Acemoglu and Robinson’s (2019) “narrow corridor.” Their concept of the “power of the state” or “state capacity” is equivalent to how we have defined legal property rights. A strong state is able to enhance individual authority to make decisions through the use of the law. Their concept of the “power of society” resembles what we consider the other elements of an institution (the informal natural rights and social norms). They argue that successful societies balance “state power” and “society power.” When there is “more” of one versus the other, the outcome is often various forms of tyranny and under development. The actual “boundary” of an institution is not a critical point for us. If institutions are considered only as some type of rules, but these rules then require some type of social norm or value (that are not defined as part of the “institution”) to be effective, this amounts to the same definition. For example, some define institutions as rules but then include norms (or anything else that influences behavior) as “behavioral rules.” Either way, it is the combination of rules along with some social constraints that matter in terms of economic property rights.

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manner, specifying what will or will not be enforced and by what means, involving norms and values regarding transaction cost behavior, and coordinating human interactions by applying to large groups of people under a specific institution’s reach. A successful institution is one that increases wealth net of transaction costs, while an unsuccessful one fails to increase wealth. In this sense, institutions are substitutes for private contracting and organizations in the effort to maximize wealth net of transaction costs. However, institutions transcend contracts and organizations, which means the latter two always exist within an institutional context. The functional relationship spelled out above means that economic ownership depends on the relevant laws, social norms, cultural mores, and religious values that identify the social context of that ownership. How the various parts of the institution work together within a given context determines how effective they are in improving the distribution of individual economic property rights and, therefore, how effective they are in generating wealth and growth.13 This applies to contracts as well. When the owner of one asset interacts and cooperates with the owner of another asset through a contract, a new distribution of property rights emerges over the inputs and good(s) produced. This new distribution also depends on the legal and moral rights that are relevant in that specific context. Contracts are made within the shadow of institutions because individual contracts rest on contract law and expectations of accepted behavior. The same can be said of an organization, no matter how complicated and hierarchical it is. An organization is a complex distribution of rights that exist within the context of legal and natural rights – its institutional environment. These legal and natural rights lie “outside” and are exogenous to the owners within the organization. Endogenous Institutions As always, institutions themselves are ultimately outcomes and matters of human actions. This means that they arise and change over time. Due to their complex nature, institutions would seldom arise from the choice of a single individual and are more likely to result from collective decisions, to evolve 13

There has been a great deal of work done on the relationship between institutions and growth. North et al. (2009) developed the idea of complementary institutional components, and developed a theory of human history in which many societies achieve a “natural state” in which “elites” have considerable economic property rights, and institutions are designed to limit access to others. Some societies become “open-access” in which institutions work to limit violence, enforce legal rights impartially, and encourage joint wealth maximization. Alston et al. (2018), also examine in detail the interaction of political and social institutions for economic prosperity. The notion that a successful institution involves its various parts matched appropriately, is an extension of the general theory of property rights discussed in Chapter 5. It is also analogous to an organization matching the various terms of its contracts to its particular circumstances of production.

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over time through natural selection, or to arise as a spontaneous order.14 Since institutions affect economic property rights, they influence the distribution of property rights in every context, and therefore the level of transaction costs and wealth in every context. Individuals have, therefore, an interest in the institutions they live under, which provides some motivation to create and alter them. For these reasons the theory of economic property rights applies and institutions maximize wealth net of transaction costs. Furthermore, this economic logic can be used to understand their formation, change, or persistence.15 Thus, the property rights approach suggests institutions are an equilibrium outcome. In such an equilibrium, it is in the self-interest of most people to consent to the institution.16 Such an institutional maximization of net wealth would be constrained efficient.17 As we view them, institutions that maximize joint wealth net of transaction costs are not free. Indeed, many institutions (like one that would prevent international wars) are too costly and do not exist. They also are contingent on the circumstances of time and place, and so one type of institution may work well in one case but not another – there is no such thing as a universal best institution.18 Likewise, within the specific context of any given time or place, the constrained efficient institutions might seem “inefficient” compared to others in other times or places. That is, some societies may be stuck with an institutional system that is the best that can be had under the circumstances, even though some other better and feasible institution exists elsewhere. This 14

15

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18

Wallis (forthcoming) argues that agreed upon rules only result from design and from within some private or public organization. Other aspects of institutions may arise through selection of spontaneous orders (Greif 2005). Because institutions are combinations of complex rights not under the control of single individuals, it is possible for the various factors of the entire system to be incompatible. These sorts of “bad” institutions would tend to inhibit wealth creation. For example, Bogart and Richardson (2011) document how Parliament was able to modify land laws during the Industrial Revolution to match the needs of changing society. Similarly, Allen (2012) examines how a series of pre-modern institutions changed in response to changes in the ability to measure fundamental units (like time and distance) around the end of the eighteenth century. Calvert, (1995, p. 60) notes: “It must be rational for nearly every individual to almost always adhere to the behavioral prescriptions of the institution, given that nearly all other individuals are doing so.” Greif (2006, p. 136) sentiments are similar. Consent to an institution does not necessarily imply participation: most would support democratic voting while at the same time not vote. See also Mittal and Weingast (2013) or Aoki (2007) on conditions for self-enforced, endogenous equilibrium institutions. Thus far, economists have only considered institutions in a partial equilibrium setting: Either the individual takes institutions as given in determining transaction costs or the transaction costs of various institutions are given to determine the optimal institutions. A general equilibrium theory of institutions is still missing. For example, Arruñada (2011) has pointed out that creating formal land titling and conveyancing systems in undeveloped countries does not always lead to greater exchange or values in land. These systems also generate transaction costs, and in some circumstances these inhibit the formal title institutions.

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means that outright declarations that “stronger” property right institutions are always better and the source of economic growth are incorrect.19 In summary, we can make some generalizations regarding institutions. First, they arise when groups of individuals cannot efficiently resolve a problem on their own through some form of contract or organization. This suggests that such groups are likely large and might include an entire society, although smaller subgroups may also require institutions. Second, they impose rules or constraints that, from the individual’s point of view, exogenously alter their economic property rights. As a result, not everyone subject to the constraints of an institution would necessarily be in favor of it. The exogenous feature of an institution means that some individuals might be caught in an institution’s net and prevented from making some sort of private side deal. Third, they are created endogenously within the economic system and survive because they efficiently resolve some transaction cost problem(s). And finally, they include social norms, beliefs, and expectations that the rules are legitimate, appropriate, and can be trusted.20 Formal laws are components of institutions, but in and of themselves they are not institutions. Institutions require general social acceptance and understanding. Thus, changing laws may or may not have the intended consequences because such changes may or may not be complemented by existing norms and beliefs. THE EVOLUTION IN CONCEPTIONS OF AN INSTITUTION

Understanding an institution as operating on economic rights through legal, natural, and social authority sheds light on early definitions. For the past forty years, two schools of thought have arisen over the definition of an institution. The first is “institutions are rules,” the second is “rules plus.” Neither school of thought explicitly links these notions back to economic property rights, even when it is clearly embedded. Institutions as Rules Among lay people the term “institution” colloquially refers to several things. Often it is used to describe grand sets of rules like constitutions and the political apparatus that go with them. Other times it describes more narrow organizations like “the church,” or “the public police.” But “institution” also commonly refers to informal social systems, such as families, friendships, and 19

20

Murrell (2010) provides a strong critique of the “strong property rights are always better” literature. This belief stems from a neoclassical consideration of property rights. When imperfect property rights get modeled as a tax on incentives to produce, it naturally follows that a reduction in the tax (without some concomitant tax increase elsewhere or reduction in expenditures) leads to greater wealth. How the rules are created, whether stumbled upon, designed, or through some process of trial and error is an interesting question, but one we will abstract from.

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social networks. At the same time, lay people clearly distinguish institutions from private agreements or organizations. In the recent social science literature, there is a split in understanding over the meaning of an “institution.” In the 1980s, Eleanor Ostrom settled on the concept of “institutions as rules.”21 She stated: Rules ... refer to prescriptions commonly known and used by a set of participants to order repetitive, interdependent relationships. ... Rules are the result of implicit or explicit efforts by a set of individuals to achieve order and predictability within defined situations. (1986, p. 5)

Most significantly, Ostrom did not view rules as “directly affecting behavior” but rather “as directly affecting the structure of a situation in which actions are selected” (1986, p. 6). North’s (1990) short, but highly influential, book also defined an institution in terms of rules; indeed, he states this in his very first sentence. Ironically, even though his book is about “institutions,” the discussion and defense of his conception is limited to just three pages of the opening chapter. His book is more about institutional change and the role this might have on economic performance, rather than a detailed analysis of what actually constitutes an institution. Without doing harm to his meaning, a selection of quotes from these first three pages describe North’s views: Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints. ... Institutions reduce uncertainty by providing a structure to everyday life. ... Institutions define and limit the set of choices of individuals. ... Institutions include any form of constraint that human beings devise to shape human interaction. ... They can be ... formal ... and informal constraints .... They are perfectly analogous to the rules of the game in a competitive team sport. ... (1990, pp. 3–4)

Voigt (2013) extends the “institutions as rules” definition. In his view, institutions are: commonly known rules used to structure recurrent interaction situations, such rules being endowed with a sanctioning mechanism in case of noncompliance. (2013, p. 13)

Here, an institution only includes common rules that regulate repeated interactions and are backed by some sort of punishment.22 One of the stronger defenders of the rules based definition of institutions is John Wallis. In Wallis (forthcoming), he identifies institutions “as agreed upon rules.” These rules might be very local (like a contract or rules for employees in a firm) and not generally considered institutions in the lay sense. He notes 21

22

She followed, most directly, Plott (1979) and Riker (1980). An issue with the large literature on institutions is that there are many definitions of institutions, and the word “institution” verges on meaning “anything.” Alston et al. (2018) also exploit the Ostrom and North notion that “institutions are rules that constrain” as the base for their own understanding. They, along with Voigt, make distinctions among institutions based on what the rules are, to whom they apply, how are they applied and enforced, and who does the enforcing.

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that some rules are not followed in practice, can be “ignored” in terms of behavior, and are only enforced when there is a dispute. These “impersonal default rules,” he claims, are generally conducive to economic growth. Like others, he goes into great detail on a taxonomy of various types of rules. Institutions as Rules ... Plus On the one hand, it is unobjectionable to claim that an institution is a humanly devised constraint. Institutions must impose constraints. However, such a definition seems only necessary and not sufficient for an institution to exist.23 As noted in the chapter on contracts, an owner of large-scale equipment might constrain its size and features through design, or constrain workers who use it by limiting how and when it is used. The owner of the equipment might also alter its size and features in order to prevent overuse of unpriced attributes. However, when a construction company limits how an employee can use its John Deere excavator, or when John Deere produces a range of excavators that vary in size in order that owners can use the appropriate size, these hardly seem like examples of “an institution.” Other restrictions might come in the form of contract details that alter the worker’s incentives and limit the exploitation of unpriced attributes. The specific economic property rights defined by a contract limit and constrain the ability to exploit any unpriced attributes. A share contract cedes different rights to the contracting parties compared to other forms of contracts, and these different rights constrain the contracting parties. Again, it stretches the meaning of “institution” too far to call a specific type of contract an institution simply because it is a humanly devised (or agreed to) constraint that shape interactions.24 Private orderings are not institutions. In contrast to those who see institutions as only agreed upon rules, Avner Greif has put forth a broader notion: ... a system of social factors that conjointly generate a regularity of behavior. (2006, p. 30)

Greif does not completely reject the view that “institutions are rules,” but considers “institutions as only rules” as a special case. For him, considering only rules implies a top-down understanding of institutions, and forces the analysis to concentrate on political organizations and explicit matters of enforcement.25 Greif also notes that rules only work if there is some “meta-rule” behind them 23 24

25

If institutions were nothing more than explicit humanly created rules, then poorly performing economies would simply copy them to full effect (Aoki, 2007). Perhaps in anticipation of this critique, North invoked the metaphor of a sports league that has a set of “rules of the game.” However, a sports league, like the NHL and its hockey rules, hardly meets the social meaning of an institution either. The NHL seems closer to an organization that provides sporting entertainment, despite literally creating “the rules of the game.” This is likely why those who understand property rights only in terms of legal rights, generally find the North’s early conception of an institution so appealing: legal rights are formal rules.

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to encourage people to follow them. Furthermore, concentrating on “rules of the game” treats institutions as “monolithic entities” (2006, p. 14), when they are likely much more nuanced. There are many institutions in society, and they are often intertwined like tree roots in a forest, even when their sets of rules might appear independent.26 For Greif an institution is made up of multiple distinct factors (elements) that form our beliefs, norms, and expectations. These factors, along with rules, might even become embedded inside an organization in order to work together toward some social purpose. Hence, Greif understands institutions as a “system” that arises to coordinate behavior to some end, and this system is exogenous to any individual who is influenced by the institution, but endogenous to the economy.27 Somewhat consistent with Greif, North’s ideas evolved over time. North (1981) introduced the role of culture and beliefs that could encourage or impede institutional change. North (1992, 2005) further developed this idea around societies constrained by “belief systems.” He came to see institutions as both formal laws and regulations, as well as informal conventions, norms, and self-imposed constraints. At the end of the day our definition of an institution is closest to that of Greif and others who follow in this tradition. Institutions are not monolithic and well bounded. They are a combination of the complex legal, natural, and social rights that work to support economic property rights. Institutions may have narrow purposes (such as the rules and norms around language), or they may be used to broadly redirect individual choices in many situations so as to enhance social wealth that would otherwise not be in the individual’s private interest (as when they discourage theft). TWO EXAMPLES OF INSTITUTIONS

Marriage Nothing is more common and ordinary than marriage. Throughout history, all successful societies have formed families around the marriage of a couple that produces their biological children. The forms these families take vary across

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The monolithic view dominates most economic work on “institutions.” It is common, for example, in the context of development to read of “replacing bad institutions with good ones,” in the same way one might change the oil on a car. Not only are institutions not singular, but the components of one institution are likely also the components of another. See Greif (2006), Chapter 2 for his elaboration on institutions. Mokyr (2014) also explores the relationship of “culture” and institutions (which he understands as the formal social incentive systems), to go beyond the “institutions as rules” concept. Likewise, the philosopher John Searle (2005, p. 10) defines an institution as “any system of constitutive rules” that have a particular social meaning in some particular context.

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Family regulation Entry rules Social norms

Family Law Property rules

Exit rules Sex laws

Couple (Private agreements)

Religious orders FIGURE

8.1 The institution of marriage

cultures and time, but marriage remains something that everyone recognizes regardless of the era or location. The variations in it are quite secondary.28 Marriage is an exemplar institution. On the one hand, marriage revolves around the attraction, love, and private agreements between a couple, and therefore has private contractual elements. Privately, the couple is engaged in trade, ceding rights to each other. These contractual elements, however, are not marriage and can be had by any cohabitating group. Actual marriage involves solemnization by either the state or a religious authority, and almost always informally involves other third parties. Consider Figure 8.1, where the institution of marriage is represented by the systems of legal, natural, and social rights shown on the left. A modern marriage depends on the law. Marriage law regulates rules of entry (who is allowed to marry whom, at what age, etc.), rules of exit (grounds for dissolution, custody of children, division of property, etc.), property rules (inheritance, marital property, etc.), and perhaps a set of sex laws that determine what is legal or illegal sex (rape, sodomy, beastiality, etc.). Marriage means that the state is directly involved in the union’s creation, dissolution, and the set of fixed rules that regulate property, support, custody, and grounds for divorce.29 These laws are exogenous to the couple but influence their behavior. 28

29

Economists, despite neoclassical models of the “household” ignored the matter of marriage until Cheung (1970b) examined the enforcement of property rights in marriage within the context of historical China. Cheung defined marriage as a “contract.” Becker (1973) considered marriage as a type of firm that produces commodities by combining time and market goods. Becker models cohabitation, however, and his model actually has nothing to do with the institution of marriage. Although the rules vary from one jurisdiction to another and across periods of time, within a given jurisdiction, marriage almost always has the same meaning in terms of third party regulation among all couples.

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But marriage is not solely defined by the legal rules; indeed, marriage existed prior to the formation of state rules. Religious organizations can impose formal sanctions on members under the threat of excommunication, define a set of objective moral values within the context of marriage and the extended family, and provide resources through financial aid, counseling, or extended friendship. Depending on the society, even nonmembers may be influenced by the meaning and value of marriage as defined by religious organizations.30 Other factors that clearly restrict, influence, and coordinate the actions of a married couple are the immediate and related family members, along with the wider community the couple lives within. Immediate family members on both sides may have considerable effect on the choice of spouse, the major family decisions, and the daily decisions of the individual couple. The same goes for the general community, which might informally impose sanctions on unacceptable public behavior. These legal, natural, and social rights are inputs into the economic property rights of the married individuals, and they alter the division, scope, and strength of rights within the marriage.31 All of these factors, therefore, make up the “institution of marriage.” Marriage is the “formal and informal rules,” the “system of factors,” or the “legal, natural, and social rights” that work to affect couple behavior through their individual property rights. Dueling Marriage is an example of an institution that can apply to anyone in a society, but institutions can also be restricted to subgroups. Duels of honor, which took place between 1500 and 1900 A.D. is such a case. Duels were instigated by two people who had a dispute and wished to resolve it. Disputes are often dealt with privately between the parties, through the use of mediators, or even the courts. Dueling, however, was a regulated activity that involved formal laws, private organizations, and many social customs. Hence, there was an institution of dueling. Duels were the sole domain of aristocrats and were not fought over serious crimes but over issues of honor (a bad look, a slap to the face, or an accusation of lying). More interestingly, they were conducted with a limited set of lethal weapons (rapiers, sabers, and later pistols) and were conducted along a specific set of privately designed, but socially accepted, rules, which evolved among aristocrats over time. These rules determined how matters were to proceed, who else could be involved, what event would trigger the end of the 30 31

In the eleventh century, European Jews prohibited polygamy, presumably to conform to the rules of the Christian societies within which they lived. At the same time, it is quite possible that the various factors also influence each other. When the formal laws of the state change, these change the actions of families, communities, and religious organizations. For example, changes in the grounds of divorce to no-fault led to changes in family transfers, the social meaning of marriage, and informal sanctions based on previous faults.

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duel (first blood, number of shots, etc.), and what the consequence of feigned effort would be. When these rules were violated, enforcement and punishment were not done by the state. Rather, the failed participant was banished from aristocratic society and socially punished by the other members. There were also formal state laws that made dueling illegal. When an aristocrat was caught dueling, however, no legal action took place unless the rules were not followed. On the other hand, if a commoner outside the ruling class was caught dueling, they were charged with attempted murder. Dueling was only nominally illegal for aristocrats but effectively illegal for commoners.32 Hence, like marriage, a figure similar to 8.1 could be made for dueling. Two aristocrats in a dispute had some liberty in determining how to settle it. However, they were both constrained by social and legal authorities in conducting a proper duel. The combination of these socially arrived at rules and enforcement, along with the legal regulation constituted the institution of dueling. WHY INSTITUTIONS ?

It is well beyond the scope of this book to provide an exhaustive list of how institutions are formed to efficiently mitigate transaction cost problems. Instead we briefly outline how this might be the case for the two examples just used. Why Marriage? Why have all societies found it necessary to form the institution of marriage? Most who study the family conclude that marriage revolves around the desire to produce biological children in conjunction with a general sexual attraction between men and women that often results in children as an unwanted byproduct of sex. On the one hand, marriage mitigates the transaction costs of couples producing their own children. On the other hand, it also mitigates the transaction costs that arise over unwanted children, and the problem of producing enough high-quality children for a society to perpetuate and be successful. The private production of a sufficient number of high-quality children is fraught with transaction cost problems. Women will only cede rights to their children and collaborate with men on a long-term basis if the men are willing to support them.33 Women must be convinced of this support over the life cycle of raising the family, and this commitment on the part of men is difficult to produce. Men will only provide support if they believe that the children they 32 33

For more details on dueling, see Allen, Chapter 4 (2012). Edlund (2006, 2013) and Edlund and Korn (2002) argue that differences in fecundity between men and women gives ownership of children to women. Marriage, according to them, is mostly designed to manage the exchange of children for support.

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are supporting are their own. Men may be concerned about the fidelity of their wives who might have sex with higher quality males.34 Paternity is just one context where transaction costs can arise between couples. There are physical differences between men and women that can lead to violence and rent extraction. There are differences in preferences over ethical behavior, the dynamics of life-cycle events, and the costs of childbirth. There are differences over the timing and level of specific household and marriage investments that lead to bargaining problems. Differences in the demand for sex over the life cycle can lead to different bargaining strengths between men and women over time. These problems can be mitigated by institutional restrictions on the choices of spouses.35 The institution of marriage involves a wedding with vows that include variations on “forsake all others,” “for better for worse,” and “till death do us part.” Promises to be faithful can reduce problems over paternity, sharing makes each spouse a residual claimant and encourages proper behavior over the numerous decisions made inside the household, and a marriage until death eliminates the last period problem (Allen 1990, 1992). The state’s ability to cost effectively establish and enforce legal rights within a marriage arise because procreation creates common types of transaction cost problems across all marriages. Thus, there can be enormous economies of scale to state regulation. When marriage relationships are mostly homogenous in terms of particular transaction cost problems, fixed state rules can substantially mitigate these costs. However, the state can also further increase the homogeneity of marriage by restricting the types of unions that can enter. The cost of restriction is the foregone gains from marriage to groups not allowed to marry.36 The comparative advantage of legal regulation within marriage was historically supported by the doctrine of coverture, and the inability of women to control fertility with any certainty.37 When fertility cannot be effectively controlled, wives will bear more children, and the wife’s investment in children 34

35

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37

This problem exists in most species that rely on sexual reproduction. Some nonhuman species even develop weak social institutions to combat it. Historically, marriage has often restricted women’s freedom of movement and ability to work outside of home. These restrictions increased the husband’s confidence in paternity. In recent decades, as DNA paternity tests became cheaper, the issue of establishing paternity largely disappeared. This eliminated the reason for restrictions on the movement of wives, especially in terms of joining the labor force. We would expect wives at child bearing age to join the labor market in earlier and in larger numbers in states where the DNA test was first accepted as a legal proof of paternity. There is a long list of research on the transaction costs related to marriage. See, Cohen (1987), Allen (1990), Allen and Brinig (1998), Matouschek and Rasul (2007), Wickelgren (2007), or Barzel (2011). When marriage is restricted to heterosexual couples only, then laws regulating sexual behavior and procreation are more likely than when marriage is not restricted based on sexual orientation. Coverture was the doctrine of a wife taking on the legal identity of her husband at marriage. See Chapter 12 or Geddes and Lueck (2002) for property rights explanation of its rise and fall.

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are specific to the union. This enormous specific investment is made by all wives, and puts them in jeopardy of rent seeking on the part of their husbands.38 Because all wives faced this problem, they historically controlled the legal property right over the duration of the marriage. This was achieved by making divorce subject to specific grounds, such as adultery or desertion. Such grounds would often require mutual consent in order to prove in court, and the mutual aspect of divorce meant that the spouse least wanting to terminate the marriage (usually the wife) controlled the right to divorce. The state’s ability to efficiently enhance marriage is thwarted when the roles of the spouses vary substantially from one marriage to another. In addition, different types of living arrangements may generally require different rules and stipulations. This reduces part of the gain from standard legal marriage rights. Under these circumstances, the state loses part of its comparative advantage, and is likely to defer to private contractual agreements or to other cultural, religious, or social factors in the institution of marriage. Although spouses engage in private actions that enhance their economic rights within their union, the state and other parties intervene in these unions by creating a set of uniform legal, natural, and social rights that complement the private efforts. The institution of marriage increases the value of individual marriages, per se, by reducing the transaction costs of marriage unions. In the case of marriage, the institutional response may also have a social benefit of encouraging fertility and the production of high-quality children. Why Dueling? Understanding dueling requires an understanding of the role of pre-modern aristocrats. This social group was the pre-cursor to modern bureaucrats, and staffed the various offices of the state often at the pleasure of the Crown c.1500–c.1900. They existed in an era when the measurement of basic things – like time, distance, weights – was difficult to do with any precision. During this period, a public office was often given out as a form of patronage. That is, the owner of an office (who could be the King or some other aristocrat) gave the office to an individual and trusted that the holder would do their duty. There were many types of patronage offices, from the great offices of the state (e.g., “Lord Privy Seal”), to lower offices in some public organization. These offices were profitable, and highly sought after. To have one, the holder had to be part of the elite social order and be accepted as a trusting member. Many members of the upper aristocracy could be trusted, but the marginal aristocracy was made up of various young members of the gentry. Why would the Crown trust one of them to hold an office? 38

Cohen (1987) argued that wives make their major child-centered marital investment in the early years of the marriage while husbands contribute largely later on through financial contributions. This means that husbands in mid-life can gain by leaving their wives and seek a higher quality one with their higher current income.

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Office holders were trusted because they stood to gain when honest and stood to lose tremendously when found out to have cheated their patron. This trust was based on the enormous investment aristocrats made in specific sunk investments. Wealthy aristocrats invested in estates, parks, education, and extravagant living. These options were not available to less wealthy marginal gentry, however, who could only invest in sunk social capital. Social capital involved investments in relationships and required the recognition of other aristocrats to be useful. Social capital arose from investments in dance, music, Latin, hunting, and the art of conversation. If others failed to acknowledge one’s social capital, it was of no value. Once invested, any unacceptable behavior could be punished with ostracism. This was a severe punishment because an aristocrat’s entire social life, business connections, and persona were based on being part of the aristocracy. Allen (2012) argued that the problem with social capital was that it was not directly observable. If not observable, then it could not be used to police trustworthy performance. But now comes the duel. The duel was an ingeniously designed screen, and separated out those marginal gentry who had made a sufficient social capital investment from those pretenders who had not. The screen worked quite simply: either the disputants participated in a duel or they did not. The duel was designed such that only those who had made the sunk investment found it in their interest to proceed and accept the risk of death or injury. A pretender who had not made the social capital investment would find it in their interest to reject the duel given the chance of death. Thus, participation indicated that one was trustworthy. A failure to participate meant that the social capital was lacking. Dueling was costly, but it solved a transaction cost problem of the day better than any alternative. Dueling helped the aristocratic class filter out pretenders who, like the wolf in sheep’s clothing, would cheat them in an environment based on trust and not measurement. INSTITUTIONAL CHANGE

If institutions are distributions of property rights that mitigate transaction costs in a constrained efficient fashion, then they should change when the transaction cost circumstances change. Marriage changes when paternity can be known through testing or pregnancy controlled through the pill, and dueling ceased to exist when modern measurement allowed for bureaucrats, paid by the hour, to staff government offices. In this section, we briefly consider aspects of legal rights as examples of how institutions might change over time or across circumstances in response to transaction costs issues. The Emergence of Legal Rights Consider how a rule of law might emerge out of a stateless beginning, where very modest economic property rights exist with no institutional support; that

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is, in a world without legal or natural rights.39 At this beginning, diverse individuals are distributed over space, and they use their strength and wits to survive, to maintain ownership over themselves when not enslaved, and to acquire possessions. With the passage of time, people accumulate information about others, and as they become acquainted they engage with each other through exchange. With no third party to compel performance, all exchange agreements are restricted to self-enforced ones. Exchange benefits from specialization enhanced by comparative advantage. The exchange between individuals specializing in production and those specializing in protection is of special significance. One who specializes in protection increases the strength of other’s economic property rights, and increases the types of choices the original owners can make with what they have. Thus, among other things, agreements with the protector will spell out the price of protection in terms of goods, which necessarily requires some specification of the protection provided. This is a prototype of legal rights. Legal property rights inevitably emerge through self-enforced agreements between goods producers and protectors. These agreements are entered voluntarily because each expects to gain from the exchange. The ability of the protector to credibly specify the rights that will be enforced might be very limited, but to the extent possible, the protector necessarily erects some type of rules for the territory he protects and becomes the “ruler” of that territory. If this exchange is voluntary, then the legal rights supplied must strengthen the economic rights that already exist. Moreover, new types of choices might now arise with the protector – the protector might allow for new products to be produced that were not worth making when each individual was responsible for their own protection – increasing the scope of the individual’s economic property rights. Protection and the specification of legal rights – which are some of the basic functions of the state – may thus arise as the consequences of the quest for private gain. These institutions are costly to produce, and so the protector never creates perfect economic property rights. To be able to perform policing functions, rulers must be stronger than their subjects. This strength is enhanced when the protector-ruler possesses economies of scale in the protection between neighbors and against outsiders. Unfortunately, rulers might also covet the wealth of their subjects. This creates the problem known as the “sovereign’s paradox.” Who is willing to engage with a powerful protector who might have his eyes on their properties? In response and if possible, some sort of collective-action mechanism might be formed to control the ruler before installing him. Such a mechanism would be part of the political institution that works along with the legal institution of the protector. Successful states, then, will place constraints on the ruler that

39

For an elaboration of the ideas in this section, see Greif (1998), Barzel (2001), or Bates et al. (2002).

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accompany his installation.40 Constraints might include limits on the size of the force under the ruler’s personal command or restrictions on the form of remuneration and the length of tenure. Employing a ruler partly by a residual but mostly for a wage with supervision makes the ruler largely a supervised manager of the protection effort rather than its primary residual claimant. Such an arrangement arose with the institution of the podesta. Many medieval city-states in Italy imported a ruler (podesta), typically for a one-year period, and paid him a fixed reward. Such controls and remuneration methods reduced the incentive to specialize, but reduced the possibility that the podesta could organize a takeover and amass enough wealth to finance it.41 It also seems plausible that there would be scale economies in the delineation of borders between neighbors and the adjudication of disputes that might occur. The ruler’s ability to protect assets might be complementary with protecting trade. If so, the protector then becomes the low-cost provider of protecting trade, and his subjects should encourage provision of legal services to facilitate trade and make use of third-party adjudication. The more standardized the traded commodities, the easier it is to trade by contract, and the greater is the advantage of scale economies. The more homogeneous an area, the larger the expected state size; likewise, the more standardized the goods produced in the area, the greater the expected scope of the state. In this scenario, where subjects maintain tight control over the protector, there must be a balance of power between them, along with safeguards to preserve the balance over time. The safeguards cannot be perfect, however, and external shocks due to such events as foreign conquest or plagues will upset the balance. The likely outcome of an upset balance is a dictatorship. Once a dictator takes over, the state’s economy is likely to decline and stagnate. Nevertheless the initial dictator and his successors are likely to cling to power. It is difficult to return to the rule of law; consequently, we see that history has been dominated by dictatorships, civil strife, and often rebellions.42 40

41

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Given the English model, the notion of a king (and a hereditary regime) seems natural. The city-state of Venice, however, provides an even better example of constrained rulers. Starting its independent existence around A.D. 600 and ending in 1797 with the Napoleonic conquest, Venice seems to be the foremost example of a constitutional, or rule of law, regime that did not turn into a dictatorship. The ruler position in Venice (the dogeship) was not hereditary, and the power of the doge was rigidly constrained. Acemoglu and Robinson (2019) discuss the role of the podesta in their chapter on “good governments.” The sovereign’s paradox might be resolved through an ecclesiastical constraint. A strong church, representing a commonly held religion, can act as a check on the ruler’s power. Of course, now the head of the church must be prevented from exploiting his power at the expense of the subjects and king. For successful states it is expected that the more authority the church’s theology grants the church leader, the more constraints that will be placed on that church leader before being granted the office (Allen, 1995). Acemoglu and Robinson (2019) also note that a balance between the powers of society and state authority must be constantly kept. Another relationship between property rights and the state is posited by North (1981), who emphasizes the effect of clear delineation on growth.

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Property and Contract Law Once a legal state is in place, the legal institutions themselves will evolve based on the specific circumstances of time and place. The English legal system is based on the common law, which involves laws created by courts and modified through legislation. The common law is divided into various branches, such as contract, property, torts, criminal, and family law. These bodies of laws differ from each other, and each deals with matters that have economic issues in common. For example, property law deals with matters of real and intellectual property. Smith and Merrill (2011) have well argued that property law is not the same as “property rights,” and it is wrong to think of this body of law as an ad hoc “bundle of sticks.” Rather, property law has an economic logic based on mitigating transaction costs, and takes on a specific form that distinguishes it from other branches of the law. That is, it is an element of the institution of law that has evolved, adapted, and changed to suit its purpose. One of these features that Smith and Merrill emphasize is the in rem nature of property law. In rem rights “create duties on noninterference in all persons” (Smith and Merrill, 2011, p. S81), and means that such a right is “against the world” and not related to a specific set of individuals. Thus, when someone has a legal right over, say a car, those rights are against everyone and this becomes an understood feature of rights to real property. If someone were to steal a car, they could not claim that they thought that the owner of the car did not possess the right of exclusion, or that they in particular were not excluded from taking the car. The in rem right of exclusion is a long-standing feature of legal rights to property, and means that these rights tend to be standard and difficult to change through contract.43 Smith and Merrill argue that the in rem right of exclusion is the backbone of legal ownership of property, and announces to all that the legal owner is the “gatekeeper or manager of the asset” (2011, p. S90). This allows for an enormous information cost savings for the multitude of human interactions that involve real property because individuals do not have to investigate, for every single good they encounter, what the specific rights of ownership are. As a result, the same legal rights of property can be an input into the economic property rights of a multitude of assets, and act to regulate, enforce, and coordinate the use of the asset through the choices made by the economic owner.44 Furthermore, because the in rem nature of property becomes 43

44

Arruñada (2017) notes that because land exists through time, contracts over land are sequential. Contracts in the past that may be costly to learn about, therefore restrict the value of future contracts. The transaction costs over “sequential exchange” can be reduced by various forms of titling, but also by creating in rem rights to land that restrict the ability to contract at any point in time. Here is the similarity to family law, which is standard within a jurisdiction, and plays the same role in mitigating information problems in human marital relations. When one meets a married couple, it is understood what legal meaning this has, and how this plays into understanding

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a common understanding, it aids in the formation of beliefs about ownership and the expectations one has when an owner. In Chapter 6, we discussed the role of contract law in the enforcement of contracts. Contract law recognizes that the rights established by contract are in personam; that is, they are rights that apply to specific people. As such, these rights can be customized to the individual needs of those entering the contract. Hence, in the case of farm contracts, the specific details of the form – whether a rental or share contract – can depend on such things as the specific crop grown or the specific parcel of land used. Generally speaking, there is no broad social interest in the details of a contract, and so the body of law that spells out the legal authority within the contract can deal with matters unique to contracts. To the extent, there are common issues across contracts, there can be common contract law restrictions that can then help regulate, enforce, and coordinate contracts. In this sense, contract law would also help form beliefs and expectations about the exercise of a contract. These factors, along with norms and moral codes of conduct, work together to support the economic property rights within a contract. The history of both English property and contract law is too long to detail, but we see that there is a property rights logic to it. In both cases, the institutional details resolve transaction cost problems at the relevant level. In both cases, the specific transaction cost problems explain the fundamental differences of the two legal branches. Criminal Law and the Police One final example45 suffices to show how specific institutions evolve based on efforts to maximize wealth net of the transaction costs involved. As discussed in the previous chapter, an organization arises when the optimal distribution of property rights that results from some form of production do not alone create sufficient incentives to direct that production. Thus, wage contracts may be necessary to mitigate workers from exploiting various attributes of the productive assets, but the wage contract creates low powered incentives. To offset the weak incentives of wage contracts, some other asset owner may assume the role of organizing, directing, and guaranteeing production. Within the context of an organization, another problem might arise: outright theft of the productive inputs or output. Since the various owners of the productive assets often have access to other inputs and the final product, this access might allow for theft in the form of fraud, breach of trust, or larceny. When the central owner of the guarantee capital has a comparative advantage in policing theft, we expect that matters will be dealt with privately. However, when this owner has no such advantage it is possible that an institution may

45

the interactions one might have with the couple because it is the same for all legally married couples. This example is taken from Allen and Barzel (2011).

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emerge that not only provides this service to this particular organization, but to other organizations as well. This institution might be completely exogenous of any organization using its ability to police the theft, and therefore acts as an institution by our definition. The emergence of public police and the use of criminal law to police theft within firms, as we will now see, provides an example of using the property rights approach to understand a change within the institution of justice. In Britain prior to the middle of the nineteenth century, justice was often a private affair, especially in disputes over theft between employers and their workers. Employers who thought their workers were walking away with firm property had to seek redress through civil courts. An individual violating the property rights of another would most often be privately arrested, brought to a court to be privately prosecuted before a judge, and, if found guilty, would generally pay restitution and court expenses. From the middle of the eighteenth century until the end of the nineteenth century, several new institutions were created to deal with theft, especially with respect to property crimes. New laws allowed for public police investigation, criminal prosecution, and penalties in the form of a fine, beating, incarceration, transportation, or death. The state increased its ability to search and arrest; offenses which had historically been torts began to be classified as crimes; and the number of capital offenses on the books increased.46 These changes were driven by a reduction in product quality variation, which reduced the ability of firm owners to police theft by workers. Prior to the Industrial Revolution, there was high variability in the input and output quality of almost everything produced. Because of this variability it was practically impossible for different workers to produce identical goods. Whether due to seasonal sources of power, crude tools of measurement, lack of refrigeration and dependable means of transportation, the absence of standard units of measurement, of local inputs, of minimal supervision, or of small scale artisan production, the final products were nonuniform. These goods then, were often evaluated subjectively and exchanges tended to be enforced informally through personal reputations. Disputes regarding such agreements had to be resolved directly by the parties to the agreements, as the courts were unlikely to know what the parties agreed to.47 This high variability in quality changed with the Industrial Revolution where a steady stream of innovations and new tools (industrial stamps and jigs, milling machines, turret lathes, steam power, continuous coal supplies) increased the level of standardized goods even in industries where craftsmanship prevailed.48 Standardization allowed firms to alter their marketing 46 47 48

See Allen and Barzel (2011). This transformation has been thoroughly documented by Becker (1983) in the context of embezzlement statutes, and by Fletcher (1976) in the context of larceny. See Barzel (2004) for a discussion. For discussion of these innovations, see Berg (1994, pp. 269–270), Rosenberg (1963), Szostak (1991, p. 127), and Mokyr (1999, p. 106).

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methods, make sales across greater distances, and change the way they organized their workforce to improve performance.49 Standardization, however, brought with it new problems. New opportunities for theft arose because the very feature of standardization that lowered the costs of exchange through markets and contracts, also lowered the cost of fencing stolen goods and increased the costs of protecting goods from theft – including theft by employees. Standardization lowered the cost of fencing stolen goods for thieves because the thief selling a standardized good could transact anonymously and reduce his exposure. Standardized goods made those fencing and purchasing stolen goods less vulnerable to being caught.50 The emergence of standardized goods, therefore, caused a transaction cost problem that the owners participating in production had difficulty dealing with. The increased costs of identifying stolen goods brought about by increased standardization led to two major institutional changes. First, standardization led to changes in the definition of what constituted a crime. Past practices that had not been criminal were made so, and the form of punishment changed. Second, standardization led to the formation of public police. The advantage of the police arose over investigating and prosecuting theft, especially as markets broadened beyond the scope of any individual owner’s ability to investigate. Other things equal, when goods became more standardized, then it also became efficient for the police to resolve theft. When goods were less standardized, private theft resolution by the individual owner was more efficient.51 CONCLUSION

The fundamental building block of all behavior is an economic property right to something. As long as a human is living, there exists an economic property right at a minimum to sustain him: Robinson Crusoe made choices, even before Friday showed up. In a Hobbesian jungle where life is brutish and short, (weak) economic property rights still must exist. All acts of production and exchange can be distilled as means by which economic property rights are exercised.

49 50

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Szostak (1989, p. 355). There are several reasons for the lower likelihood of being caught. First, uniform goods hinder an owner from investigating a theft. Second, when the transportation costs are low, goods can be sold in far away markets. Third, preventing the theft of standardized goods involved a collective action problem. Any private effort to reduce theft and black market sales of standard goods provided a benefit to all owners of standardized goods, but the costs of this action were borne by the private party. For example, consider the practice of gleaning – the act of collecting scrap materials from production for private use or resale – which had been acceptable to employers until the end of the eighteenth century when it became defined as larceny and embezzlement. With artisan production, gleaning could be privately policed, but with standardization, inputs were too difficult to identify once off the production floor. Hence, the change in practice.

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From the earliest chapters we’ve stated that economic property rights depend on both legal, natural, and social rights, that enhance the strength and extend the scope of choices of a given economic property right. We’ve argued that when these rights are working together to some observable purpose we can think of them as “institutions.” Institutions are not just the legal authorities granted by the state, but are these authorities combined with the nuanced authorities that come from natural, social, and moral rights held by members of society. Following Greif (2006, p. 30), an institution is a “system” of several legal and social factors that enhance economic property rights toward some type of goal. Institutions have value because they enhance individual economic property rights. An institution is a complex, non-singular, collection of expectations, norms, rules, and organizations that work together to influence the way people interact with each other. As a “collection,” it is necessarily difficult to get a handle on. Even within the context of marriage, which is so familiar to all of us, the “institution of marriage” is a hard concept to understand with precision. Institutions can change – for better or worse – over time. Sometimes the purpose and function of an institution changes, while the institution itself remains in place: Many historical offices remain, long past their purpose. Other times an institution is replaced completely by another, and all the while the social function being provided carries on: Roads have always been provided, but through different institutional authorities. An institution is created by people, sometimes quite deliberately through design, and at other times rather spontaneously simply through the actions of people. Institutions arise out of the storms of revolutions and evolve peacefully through ordinary human interactions. Institutions can adapt , and they can be inert. They can generate wealth or lead to stagnation and decline. An institution is not a social “add-on” or afterthought, but rather an integral part of any economy. Often the evolution of institutions is the subtle driving force in history. And all of this happens through the support institutions have on individual economic property rights. Our contribution is to show the linkage through which an institution matters. In the general institution literature, there are claims that institutions “reduce uncertainty” or perform some other function. These claims might be true, but if so, it must be through the affect an institution has in enhancing the economic property rights of individuals. The actual way an institution enhances these rights through the creation of legal and natural rights might be very different from circumstance to circumstance because ultimately institutions depend on specific transaction cost problems.

P A R T III

ESTABLISHING PROPERTY RIGHTS

Property rights are never perfect because of the ubiquitous nature of transaction costs. This means that necessarily some or all of a commodity’s attributes lie in the public domain, available for capture by others. Capture is a critical aspect of establishing property rights, and this section develops and extends this idea in detail. Chapter 9 goes through the mechanics of capture within the context of specific rules in order to identify some capture equilibrium outcomes. Most notably, one common outcome is that the costs of capture completely dissipate the value of capture at the margin. This analysis is then applied to price controls. Chapter 10 examines a classic question in the analysis of property rights: How do property rights evolve over time? One can think of this as the evolution in the distribution of property rights. Such an evolution can involve changes in the division of ownership over attributes or changes in the scope or bundle of rights. The evolution may also involve increases in the strength of existing rights. There is no reason for a natural progression of property rights to move toward improved strength, however. Rather, there is an ebb and flow as property rights move in and out of the public domain or have other changes to the distribution of rights as conditions change. This chapter examines the ownership of roads, goldmines, the North Sea oilfields, water, the optimal bundle of attributes contained within a commodity, and the role of courts in forming rights. When asset attributes are in the public domain, there are costly efforts to capture them. In general, actions will be taken to mitigate this capture cost. However, the very act of capture may be of value to an owner, and as a result, sometimes goods and their attributes are placed in the public domain in order to achieve some complementary benefit. A restaurant, for example, may underprice some of their meals at particular times in order to create a 159

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queue outside the restaurant. Such a queue may attract attention and provide a form of advertising. Chapter 11 examines in detail the largest historical case of assets placed in the public domain: the homestead and railroad land grants of the nineteenth century. In the U.S. these grants gave away lands equal in size to one California and two states of Texas.

9 Capture in the Public Domain

INTRODUCTION

Part I developed a central property rights idea: Transaction costs are always positive, and therefore, economic property rights are never perfect. Although there may be situations where ownership is strong enough that the neoclassical model and its Coase Theorem prediction are reasonable approximations of the real world, perfect property rights remain a theoretical benchmark, not a reality. In most cases, transaction costs are sufficiently large that the distribution of property rights is important for resource allocation.1 One important implication of imperfect property rights is that some valued attributes lie in the public domain, which means that a portion of a commodity’s value is available for capture by others. In the present chapter, we examine the nature of maximization in the face of valuable attributes lying in the public domain. Numerous equilibrium resolutions in such circumstances exist, each involving different distributions of property rights. We begin by analyzing the case of capture where property rights are acquired through the use of time. Although this is a specific mechanism, several properties of this equilibrium are common to other methods of capturing property rights. RATIONING BY WAITING

Waiting as a method of capture is common around the world. Waiting often occurs when something that has been previously owned gets subsequently placed into the public domain. The placing of attributes into the public domain might be an explicit and intentional choice, as when a firm offers free samples to its first one hundred customers; it may be an indirect result of a particular unpriced attribute not being protected by its owner, as in the case of apples 1

A situation in which transaction costs are low also depends on the immediate circumstances that allow for strong perfection. A change in the environment might create a transaction cost in what is otherwise the same situation, turning off the Coase Theorem prediction.

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hanging over a fence and above a sidewalk; or it might be the consequence of a slow price adjustment that causes an excess demand for the commodity, as in the case of a supermarket during peak times. When people wait for some specific good, that good is being allocated by time rather than by price – time is the mechanism used to establish property rights over the attribute that is unowned. Time seems a strange choice of mechanism to allocate because time spent waiting is costly for the one waiting but of no immediate benefit to the one selling or giving away the good. For example, the cinema owner who fails to price better seats to clear the market seems to gain nothing by having patrons line up early to obtain the better seats. And this assumes that the queue is orderly and somehow policed by a third party. Not all lines are so peaceful. Suppose it is publicly announced that a package containing a million dollars is to be given to the first person in line at a particular place. It might seem that anyone who hears the announcement would rush to be the first at the site and wait for the package to arrive. If, however, the line is not policed, the ultimate owner of the money is likely to be someone with an armored truck and a machine gun. In the absence of policing, those who hear such an announcement will probably not bother to join the queue unless they are able to compete effectively with weapon owners. Competition for things in the public domain may take a variety of forms besides waiting or the use of firearms. The specific nature of the restrictions delineates the margins of competition.2 In the previous example, the restrictions are first come, first served and no policing, and the margin of competition becomes firepower rather than time. Other margins are used in other cases. For instance, higher education is often provided free or for a monetary fee lower than the market clearing price, and the margin of competition for admission becomes a combination of residency, references, and grades. Congestion is the margin of competition for public parks and for roads. Speed is the margin of competition for patents and other races. The provider of the free attributes may stipulate first come, first served and, provided the appropriate restrictions are applied, the queue will be orderly. Such restrictions are applied often, and orderly rationing by waiting is a common occurrence. In the discussion that follows we assume that a good has been placed in the public domain and acquired on a first-come, first-served basis, and that the queue that forms is orderly. We also abstract from the issue of why this mechanism was chosen in order to focus on the mechanics of allocating by waiting. For simplicity we assume that there is a total fixed amount to be given away in fixed bundles, and that individuals acquire economic rights to 2

Besley et al. (1999) discuss a different allocation criterion: the waiting list. They show that under the free provision of medical services in England, the service is rationed via waiting lists for postponable chronic treatments, and that low wage individuals choose to be on the list whereas some high-wage ones choose to obtain the service privately. The list is shortened when people die before their turn comes.

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t

p

AVp=0 4 Dt=1

Dt=4 p=0

3

8

(a) FIGURE

Dt=0

10

1

x

0

MVp=0 3

8

10

x

(b)

9.1 Demands as functions of prices or time

the bundles through the appropriate amount of waiting time. The neoclassical price-setting mechanics can be easily extended to determine the properties of this form of allocation.3 Let x be the good being given away, let the dollar price of this good be p, and t be the unit of time, say minutes. Panel (a) of Figure 9.1 shows three demand curves of an individual for good x where the dollar price is on the vertical axis. Usually it is assumed that goods are sold exclusively by price and the time expenditure is zero. Under these conditions the demand curve Dt=0 provides the maximum amount of dollars the individual is willing to spend for a given quantity. In this case, with time cost of zero (t = 0) and the money price of zero (p = 0), ten units of x are demanded. If the consumer has to spend one unit of time, in addition to the price, to purchase good x, then the individual’s demand curve falls to Dt=1 – the total number of dollars willing to be sacrificed is lower because time must also be spent. When the dollar price is zero, the total quantity demanded would be eight units. Similarly, if the amount of time rises to 4 minutes the demand curve falls to Dt=4 and only three units of x are demanded when the price is zero. When a good is rationed by waiting we’d like to know the willingness to pay for that good in terms of time rather than dollars. Panel (b) of Figure 9.1 transfers the information contained in panel (a) into a space where time is displayed on the vertical axis. We’ll first consider the demand for x in it’s marginal value form.4 The marginal value of x in panel (b) is drawn under the condition that its price is zero (p = 0). As in panel (a), when p = 0 and t = 0, there are ten units of x demanded. As the price in terms of time increases, holding p = 0, the quantity demanded falls. The marginal value function MVp=0 tells us what the maximum amount of time the consumer is willing to spend for a marginal increase in the amount of x. This, however, is not the information we require. Joining a queue is an 3 4

The model we present here was developed by Barzel (1974). That is, the demand curve x = f (p, t) is now in the form t = g(p, x).

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all-or-nothing decision – one is either in the line or not. Thus, we need to know if the total value of joining the line is worth more or less than the amount of time spent in the line. The total value is equal to the area under the marginal value function, but we can more conveniently use the average value of x (which is often called the “all-or-nothing” demand curve).5 The average value function AVp=0 is the individual consumer’s relevant demand curve for x in terms of time. The average value demand curve is interpreted this way: If the price of x in terms of time is 4 minutes (t = 4), then at most a consumer would be willing to consume eight units of the good rather than have nothing at all.6 Alternatively, if there are eight units to be given away free of monetary charge, the consumer would be willing to stand in a line for a maximum of 4 minutes per x (32 minutes in total). It is important to note that along the average value demand curve, the consumer’s surplus is zero. Individual average value demands vary, of course, because of differences in preferences, other prices, incomes, and the value of time. Some individuals will be willing to pay a lot for x in terms of time because they like the good, they have high incomes (assume the good is normal), and because their value of time is low. Because the cost of time is a parameter in the demand function, those willing to pay the most for the good in terms of dollars are not necessarily the same people who are willing to pay the most in terms of time. This becomes very clear in public discussions regarding tolling roads. High time cost people often favor tolls to allocate road space (allocation by price), while low time cost people prefer no tolls and have allocation by congestion (time). In panel (a) of Figure 9.2, we have drawn the average value demand curves for four individuals (assume there are 1,000 people in total, but the demand curves of the others are not drawn). People who join the line pay nothing for the good in terms of price, but must wait in the line. Waiting in line gives them the property right over k units of the good, which here is set at two units.7 Waiting is the means by which the rights are established to the good placed in the public domain. Therefore, given its definition, the value of time spent waiting is a transaction cost. From panel (a), we see that individual 4 is willing to pay the most in terms of time and is willing to pay 90 minutes per unit of x. For the right to obtain two units of x, he is willing to stand in line for a total of 180 (t × k) minutes. Individual 1 is least willing to stand in line and is only willing to wait 45 minutes per unit of x and, therefore, is only willing to pay 90 minutes to acquire two units of x. 5

6 7

The graph is drawn assuming there are no income effects for good x. This means the area of positive consumer surplus up to three units equals the area of negative consumer surplus to the right of three units up to eight units. If the consumer could choose how many units to consume, at a time price of 4 minutes, he would choose three units. We will abstract from the case where limits to k, combined with a particular distribution of waiting costs, lead to people rejoining the line.

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t

t

S

90 75

AV 4

60

60

AV 3

45

AV

D= AV

2

AV 1

x

k=2

(a) FIGURE

N=1000

x

(b)

9.2 Individual and market demands in terms of time

Panel (b) shows the market demand and supply curves in units of time. By assumption the good x is fixed in supply to a thousand units (N = 1000). The market demand curve is the horizontal summation of the individual average value demand curves. Together they determine an equilibrium price, and in panel (b) we see that this is 60 minutes per unit (t∗ = 60). At this price person 2 is the marginal person in line because he is just willing to wait 60 minutes per unit of x. Individuals 3 and 4 are intra-marginal waiters, they were willing to wait longer, but do not have to. These two (and anyone else willing to wait longer that t∗ ) obtain some consumer’s surplus over x. Person 1 opts to not join the line. This equilibrium has some general properties. First, the time price is determined by the total amount available and the value of time of the marginal person. Everyone pays the same time price. Second, because waiting involves a cost to the buyer but not a transfer to the seller, compared to the neoclassical model, some wealth is dissipated. That is, some of the value of x that has been placed in the public domain is used up in the process of allocating by time. Third, the dissipation of wealth is complete for the marginal person. Individual 2 was just willing to wait 60 minutes per unit, and that’s what he had to do. For the marginal person, there is no consumer surplus and the costs of establishing the property right equals the value of the good captured. Finally, the total dissipation of wealth depends on the variance of the average value demand functions. If, for some reason, everyone was homogeneous and had identical average value demands, then everyone is the marginal waiter, no one gains any consumer surplus, and the entire value of x is dissipated. Processing Time A number of interesting comparative static implications emerge from the model. One counterintuitive result is that changes to the time it takes to process a sale (which is part of the waiting time) have no effect on the amount of time spent in line, but alters the number of people in the line at any given moment. In the above example, it was implicitly assumed that good x was instantly given

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away once the “doors opened.” Consider a more realistic example where a store opens at 9AM gives x away in single units (k = 1), and the equilibrium time cost is t = 60 minutes. However, also assume it takes the store 15 minutes to process each person. What would the line look like? The equilibrium time price is 60 minutes, and whether that time is spent in line or in the store filling out forms is irrelevant. The first person shows up at 8:15AM and waits 45 minutes outside, and then spends another 15 minutes inside to fill out the form. The second person shows up at 8:30AM and does the same thing. As does the third person at 8:45AM, and as does the fourth person at 9:00AM. At 9:15AM, the first person gets his item and leaves, but then another person joins the line. The line now has a steady state of four people, and every 15 minutes someone leaves and another joins. Although the line looks shorter to an outside observer compared to when the product was instantly given away and 1,000 people showed up at 8:00AM, everyone in line still pays the equilibrium time price of 60 minutes. Suppose a store clerk discovers the form could be shorter and filled out in 5 minutes rather than 15. The equilibrium price remains 60 minutes, but now the first person arrives at 8:05, waits 55 minutes, and spends 5 minutes filling out the form. Every 5 minutes another person joins the line. At 9:05 AM, there are twelve people in line, with someone leaving and joining every 5 minutes. The line is “longer” because it contains twelve people rather than four, and a spectator might think that the time price is higher. However, the total time spent remains the same at 60 minutes.

Line Amenities Another counterintuitive result is that making the line more comfortable and pleasant increases the amount of time in the line. Increasing the comfort of the line by offering shade or rain cover, benches, and cocktail service amounts to lowering the net cost of standing in line. As a result, the AV functions shift up, leading to an increase in the market demand for the good and raising the equilibrium time price. Therefore, the expenditures on the extra comfort are wasted! A humorous episode of such waste happened in the small hometown of one of the authors. That community had a school district that, for exogenous historical reasons, had two “fundamental” or “back to basics” elementary schools, both located in old buildings in the downtown business district. At one point, in time, the government instituted a radical “post-modern” education plan that overnight increased the demand for the “back to basics” schools. These public schools were required to offer “free” education, and so suddenly there was excess demand, and parents immediately lined up to register their children for the following year. As it turned out, the first line had to form on the edge of a busy parking lot and out in the open. In that line, parents waited about 4 hours. The following year, it was decided that parents could form the

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line on the first day of school (early September), and behind the school, under some cover, and away from cars; the first parents showed up 12 hours before the office opened. The next year it was decided that since parents had spent the night outside, they should be allowed to bring lawn chairs. The queue lengthened to 18 hours. And on and on it went ... for about twelve years. By the end, parents were allowed to have substitutes (like grandparents or teenage children) wait for them, campers and other recreational vehicles were allowed on site, the school washrooms and showers were made available, and the campers were allowed to set up volleyball nets and other recreational games on the school field. By the end, the wait for registering children was about 30 days. Essentially, families took their summer vacation on the school property. The queuing registration system was eventually terminated because cars began circling the school in late July, scouting out the first family to stake their claim in line. Once the first family showed up the rush was on and the chaos that ensued made the neighborhood traffic dangerous. Some fights broke out between families over the actual order of arrival, and some parents demanded the local school board set up a mechanism for policing the line. The ultimate “solution” was found by removing all amenities from the line, and moving the registration date to rainy January, back in an exposed parking lot. The queue is now back to about 4–6 hours. Cost of Time Rationing by dollars allocates goods to different people compared to when goods are rationed by time. High income people necessarily have high time costs, and these people are less likely to wait in lines. A lawyer who charges an hourly rate of $1000/hour is unlikely to wait for good seats in theaters or restaurants; they are simply too costly, even though he pays the same dollar price and waits the same amount of time as anyone else for the show or meal. On the other hand, low time cost individuals often prefer allocation by time, especially if the alternative is to compete with high income people in terms of price. An interesting case of low time cost allocation occurs in Disneyland. Disneyland charges an entry fee but does not charge separately for the individual rides. Hence, each ride is allocated through waiting. Most of the visitors to Disneyland are from out of town, staying in one of the nearby motels, and often without a rental car. Aside from Disneyland, there is little else of interest within walking distance, and so, while visiting, their cost of time is low. The result: The length of line for a given ride is determined only by the number of people in the park. On a rainy day in February, there might be relatively few patrons, and the wait for a given ride might be 5 minutes. On a sunny day in June, with the park packed, the same ride might have a line of 2 hours. Differences in the cost of time present an opportunity for gains from trade. One such case is scalping, where low time cost individuals purchase underpriced items, and then resell them privately. On the surface, scalping

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looks like a socially beneficial activity. When goods are underpriced part of their value is in the public domain, and individuals with low time costs stand in line to acquire them. They then resell these goods (or their position in the line) to other individuals who have higher dollar values over the good. Since the low time cost waiter seems to minimize the transaction cost of allocation by time, scalping might appear to increase welfare, given that the product was underpriced. Suen (1984) pointed out that this conclusion is not always correct. It is always the case that the marginal person in line completely dissipates the value of the good through waiting. Other people in line also dissipate wealth, but not to the same extent as the marginal person. The total amount of wealth dissipation depends on the costs of time for all of those in line, or to put it another way, it depends on the variance of time costs among the heterogenous waiters. Imagine there are two dozen potential scalpers, each with identical low time costs, and each is able in one purchase to buy all of the tickets to an underpriced sporting event. Absent collusion among them, competition between the scalpers will force the winning person to wait in line long enough to dissipate the entire value of the underpriced tickets. On the other hand, in a market where scalping was not allowed and perfectly enforced, many in line will be intramarginal in terms of their time costs, and as a result, not all of the wealth placed in the public domain is dissipated. RATIONING BY RACING

A race is a similar mechanism to waiting, but in a race, individuals wait for a starting announcement and then rush off to stake some sort of claim. Both waiting and racing use the allocation method of “first-come, first-served,” but waiting allocates based on time, and racing allocates based on speed. Receiving an MRI scan in Canada (along with most other medical procedures) is allocated by waiting, but obtaining a patent is achieved by racing to file the patent first. A fascinating, and perhaps the most famous, episode of racing took place on the plains of Oklahoma at the end of the nineteenth century.8 In 1862, the U.S. Homestead Act placed millions of acres of the western states in the public domain by giving individuals 160 acre plots if they were the first to claim them and live on the land for five years. In Chapter 11, we’ll discuss homesteading in some detail, but at the moment, we want to consider the special case of Oklahoma where the race to claim was formalized. Oklahoma was originally called the “Indian Territory” and was a quasisovereign region established for the “Five Civilized Tribes” of the south who were marched there along the “Trail of Tears” in the early nineteenth century. In the 1880s, this tribal authority was broken up through the Dawes Acts, 8

This example is taken from Allen and Leonard (2019).

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s

169

N

s** s*

D' D Land plot

FIGURE

9.3 Racing equilibrium

and private title was given to individual Native Americans in blocks of 80 or 160 acres. This process ended up returning a massive area of leftover lands in the western half of the territory back to the U.S. government. The federal government then decided to reallocate that land to American settlers through a series of races between 1889 and 1901. Racing is costly and requires effort and racing capital. The faster one wants to go, the more costly it is. How much effort and capital one is willing to put into a race depends on the value of the object being raced for, the cost of effort and capital, and the speed required to win. Only considering the cost of speed, let’s assume that an individual racer i’s all-or-nothing net willingness to pay for a plot of land in terms of speed is given by Zi (s) = Vi − ci (s), where Vi is the gross value of the land and s is a given speed. A racer is willing to enter a race if Zi > 0. Suppose also that there are N units of homogeneous land up for the taking in the race, and that each racer can only take one plot of land. The market demand for land plots is the horizontal summation of all the individual unit net willingness to pay functions Zi . This demand is downward sloping: As the price of speed falls, more people are willing to enter the race. The low valued demanders of land either place a low value on the land itself or are high cost racers. This demand curve, along with the fixed supply of plots is shown in Figure 9.3. The intersection determines the equilibrium speed s∗ . Those individuals for whom Zi > s∗ enter the race, each goes at the same speed, and each receives a plot. For the marginal racer, just like for the marginal waiter, the value of the land is completely dissipated through the cost of racing. Those intra-marginal racers receive some surplus. If the value of land increases, or the cost of racing falls for everyone, the demand curve shifts upwards, leading to a new, higher equilibrium speed s∗∗ .

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170

Nh

s

sh Nl

Dh

Dl s l =0 Land plot FIGURE

9.4 Heterogeneous land qualities

Of course, not all land is the same. When land quality is not homogeneous there are essentially multiple races for each category of land quality within the race territory. Suppose there are two levels of land quality: high and low. Let Nh be the number of homogeneous land plots of high-quality qh available for homesteading and Nl be the set of low-quality homogeneous land plots (ql < qh ). For both Nh and Nl there are separate race markets, with separate equilibrium speeds sl and sh , which also depend on the relative demands for the different quality lands. Adding more plots of different qualities simply increases the number of races. Figure 9.4 shows the separate high-and low-quality markets, where it is assumed that the low-quality land is not scarce. Individuals race for the high-quality lands, but there is no race for the low-quality, and some low-quality land is not taken. Figure 9.4 explains one of the puzzles of the Oklahoma rushes: Not all of the land was taken in the races. Across the entire western half of the state there were six massive areas that had races. The quality of land varied across and within the six areas. Thus, even by 1920 the worst areas still had around 40 percent of the land unclaimed. THE ANALYSIS OF PRICE CONTROLS

Government attempts to control prices started in the ancient world – they’ve been around forever. In the twentieth century, there were price controls in western countries on wages, apartment rents, foods, and gasoline. In more recent years there have been price controls on wages, medicare, and pharmaceutical drugs. The rising prices of housing around the world in the past decade has led to a resurgence of calls to legislate fixed prices for housing and real estate fees. Among non-economists, price controls are often thought of as means of reducing scarcity or eliminating inflation, and interest in them often arises after

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some type of a shock that has drastically altered the level of scarcity or the rate of inflation. The standard neoclassical model is inadequate to analyze price controls and must be modified to recognize the role of imperfect economic property rights in the context of goods with many attributes. Price controls, fundamentally, place attributes in the public domain, and therefore capture efforts will be made to establish ownership over these attributes. In the model of rationing by waiting, queuing is the means by which ownership is established. Rationing by waiting or racing, therefore, can be viewed as a special case of price control. For example, in the case of a patent, the government filing fees might be far lower than the market clearing price for it and induce a race to patent. The analysis of actual price controls differs from that of rationing by waiting in two ways. First, whereas the analysis of price control requires only that the controlled price be different than the equilibrium price, in the rationing by waiting model we assumed that the (money) price was set at zero. In what follows, we will mostly consider the case of a price ceiling where the controlled price is below the equilibrium price, but not at zero. Second, whereas in the rationing by waiting model we assumed that competition occurred only through queuing, in the price control analysis that assumption is maintained only initially. Under rationing by waiting, individuals acquire rights to the rationed commodity by spending the appropriate amount of time in the queue. Under price controls, property rights allocation is more complex because both buyers and sellers have multiple options to choose how ownership over the controlled good is to be established.9 The determination of how rights to a good are actually allocated is essential for the analysis of the controls. To begin, however, we first consider a generic price control model where waiting is the means by which rights are established to commodities partially in the public domain. Price Controls and Allocation by Waiting Consider Figure 9.5 where D is the demand curve, S is the supply curve, the equilibrium price and quantity are P∗ and Q∗ , and the control price is Pc for some simple good. Assuming that the control price is perfectly enforced, there is a discrepancy between quantity demanded, Q0 , and quantity supplied, Q1 , known as a “shortage.” Since sellers only supply Q1 to consumers, at the margin, the maximum willingness to pay for that quantity is P1 . A naive analysis of the price control would suggest that since consumers are willing to pay more for the good than the controlled price there is a transfer of wealth from sellers to consumers equal to the hatched area. At the same time, the consumer and seller surplus over the quantities (Q∗ − Q1 ) is now lost because those units are not produced, creating a deadweight loss equal to the triangle between the 9

See Cheung 1974, pp. 53–71.

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172

P S P1 P* Pc D Q1 FIGURE

Q*

Q0

Q

9.5 Simple price control

demand and supply curves to the right of Q1 . The examination of rationing by waiting implies that this analysis of the hatched area is incorrect. When producers only supply Q1 the difference between what consumers must pay and what they are willing to pay (P1 − Pc ) is placed in the public domain – the surplus is up for grabs. By assumption, suppose that individuals acquire ownership over this wealth by waiting. Based on our earlier analysis, the marginal person in line waiting for Q must fully dissipate this transfer, and if everyone has the same waiting costs, the full transfer (hatched area) is dissipated. For example, if Q1 = 100, Pc = 1, P1 = $1.80, each person is only allowed one item per purchase (k = 1), and the opportunity cost of time for consumers is $20/hour, then each buyer spends $1 plus 2.4 minutes waiting in line. In the aggregate, consumers spend a total of $100 in cash and 4 hours in time to purchase all one hundred units. The amount represented by the area (P1 − Pc )Q1 is the dollar value of the time expenditure. Now, rather than assuming each person has identical waiting costs, suppose these varied across consumers. It remains true that the marginal person in line fully dissipates the value of the transfer by spending 2.4 minutes in line worth 80c/ of his time. Everyone in line spends 2.4 minutes, but everyone else has a lower cost of time; therefore, everyone else spends less than 80c/ waiting and as a result not all of the transfer is dissipated. This is shown in Figure 9.6, where the hatched area is the dissipation caused by waiting (the total dissipation would include the traditional triangle as well). Note that the total cost per unit to the consumer is greater with price controls (P1 = $1.80) than without them (P∗ ). Rationing by waiting in light of price controls has an interesting historical precedence. In 1971, President Nixon imposed an economy wide freeze on gasoline prices in a futile attempt to curb inflation.10 In the case of 10

Information on the Nixon administration price controls can be found at Kalt (1981) and Rockoff (1984).

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P

S+value of time

173

S

P1 P* Pc D Q1 FIGURE

Q*

Q0

Q

9.6 Price control, heterogeneous waiting costs

retail gasoline, prices were not explicitly controlled; instead, the margins, or markups, were controlled at various stages. Only the price of crude petroleum was controlled.11 For the most part, the supply was abundant and the freeze was generally insignificant to cause visible effects, but things changed in petroleum markets as a result of the Arab–Israeli war of 1973 and the subsequent Organization of Petroleum Exporting Countries (OPEC) restrictions on oil exports. The sudden reduction in the supply of oil products, especially gasoline, led to immediate shortages of gasoline around the U.S. in the face of the legislated price controls. There were several options available to the state to respond to the sudden shortage. For instance, producers could have been required to produce the quantity Q∗ or, for that matter, the quantity Q0 . No quantity restrictions on producers were imposed, however. Or, as the shortage became severe, the administration could have estimated Q1 and issued coupons for that number of gallons. Had coupons been issued, property rights to the purchase of gasoline (in amounts not to exceed Q1 ) would have been allocated. Property rights would then have been secure and people would not have needed to spend resources to acquire these rights. Coupons, however, were not issued. There are many ways to resolve a shortage, but the property rights system that actually prevailed was waiting; that is, waiting was the equilibrating market force. The lines were not caused by “shortages” per se. Indeed, scarcity does not even imply “shortage.” The shortage arose because the price was controlled at a level below the market-clearing price. The use of waiting and waiting lines to deal with the shortages emerged in the case of gasoline because the regulator allowed it and did not allow other mechanisms. To return to the main issue, the price control reassigned seller and buyer distinct rights to gasoline. The sellers were allowed to produce whatever amount 11

The Cost of Living Council and the Internal Revenue Service were the primary agencies involved in policing and enforcement of the controls.

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they wanted to, but they had the right to the value the gasoline only up to the control price, and the remainder was placed in the public domain. Buyers could acquire the right to the remainder – the difference between the control price and the buyers’ marginal valuation – but only by joining a queue. By paying the control price plus the time price, buyers could obtain the economic property rights to a gallon of gasoline. Except for the fact that buyers had to pay a pair of prices, the market for gasoline may be viewed as having functioned normally. Indeed, there are many unregulated markets in which both money and time prices are paid by a buyer. A person who insists on eating lunch at noon in the cafeteria is facing a time price on top of the money price charged. The only difference is that in the lunch case the seller sets the pecuniary price which indirectly determines the waiting time, whereas in the case of gasoline, government set it.12 Price Controls and Allocation by Quality Adjustment Regardless of what commodity has a controlled price, even in relatively simple transactions – like the purchase of gasoline – there are numerous valued attributes exchanged and importantly many of them amenable to manipulation. During periods of price controls, market participants have an incentive to alter the levels of commodity attributes that the controller did not stipulate, allowing the parties to the transaction to capture some of the public domain values. For this reason, the actual allocation of property rights differs from what the simple rationing by waiting analysis implies. The ability to mitigate the effect of price control constraints means that price controls change the behavior of market participants in ways additional to waiting.13 In reality, people are likely to have many margins of action, and given these margins of action, wealth maximization will generate a determinate equilibrium with no need to bring “shortage” to the rescue. Wealth maximization implies that individuals will carry on an activity until, for the marginal unit, net gains are zero. Even when a price is controlled, the question must be asked: Can the buyer or the seller take additional steps to obtain or provide another unit at a cost below the added gain? If the answer is yes, equilibrium has not yet been reached. The notion of a “market-clearing” equilibrium requires that all individuals make whatever moves they wish under the existing property rights arrangement. The textbook analysis of a binding price ceiling that concludes that a shortage will emerge implicitly assumes that buyers pay in cash and that the amount 12

13

Deacon and Sonstelie (1985) exploit a gasoline price-control episode in the aftermath of the 1973–1974 era. They successfully test some of the hypotheses suggested here, as well as some related ones. The neoclassical framework provides no guidance regarding behavior under the controls. If the available units are allocated randomly among the demanders, which some think is what the standard model implies, then the deadweight loss is not the conventional welfare triangle. Rather, it is proportionate to the entire area under the demand curve above the control price.

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they receive is of the prevailing quality of the commodity at the right time and place. It ignores the possibility of adjustments, thus implicitly denying that individuals maximize if adjustments are available. Gasoline Price Controls If we stick with the context of price controls on gasoline, consider the variation in gasoline prices that exist under normal circumstances. Prices are lower at gas stations in oil-producing states, reflecting lower transportation costs; at gas stations that use low prices as promotional devices than at gas stations that use other means of promotion; and at self-service stations compared to full service stations. Prices might also vary depending on the hours open per day; the number of days open per week; the number of pumps per station; and where the station is located. When price controls are introduced, they often enforce the nominal price that exists at a given time and station, regardless of what that price actually reflects. Therefore, for example, a self-service station might end up with a regulated fixed price that is lower than a full-service station. As such, a price control always constitutes a reassignment of property rights. Although sellers are clear on what price can be legally charged, the other margins are open for adjustment. The buyer is expected to optimize regarding such things as purchase frequency, location, and time of purchase. It is essential to have specific information about the regulation of the attributes of gasoline before its effects can be adequately examined. However, ambiguity often surrounds the regulation of such attributes under price controls. Much of the ambiguity in the scope of controls stems from the great number and variability of attributes of the regulated commodity. The attributes of gasoline transactions, for example, can be classified into those of the gasoline itself and those of the services provided with the gasoline. One of the attributes of the gasoline is its octane rating, often graded as regular or premium gasoline.14 “Premium gasoline” describes a range of products of octane 90 and above, rather than strictly defining a single product. Premium gasolines differ from each other in some other ways, including performance and pollution additives, levels of ethanol, and differences in refinery methods. Price controls essentially ignore most of these variations in quality. Because it is prohibitively costly to delineate rights to all the valuable attributes of a commodity, especially the ones not explicitly delineated by sellers, it is not surprising that the control specifications made by the state are not fully detailed. Consequently, regulations consistently fail to stipulate the level of certain attributes. 14

Premium and regular grades are generally determined by industry standards through the American Petroleum Institute (API) and the American Society for Testing and Methods (ASTM). Standards are voluntary, although there are some state regulations, with varying degrees of enforcement. No single octane rating is formally specified to distinguish regular from premium.

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In the above analysis, in which gasoline was implicitly considered as a homogeneous commodity, price controls effectively allowed the seller to retain the right to a regulated price and allowed buyers to capture the remaining value which had been placed in the public domain by joining a queue.15 This conclusion must be reexamined when sellers can adjust the quality of their gasoline. When price control regulations do not specify attribute levels, the affected parties attempt to capture them, each according to their particular circumstances. To illustrate, consider two service stations, A and B, which are selling premium gasoline. Station A sells 90-octane premium for $3.25/gallon, and station B sells 92-octane premium for $3.50. If a price control was imposed that defined premium gasoline as having 90 octane or higher, then Station B will be less constrained than station A. Station A has its price fixed at $3.25/gallon and, thus, must maintain its 90 octane level. Station B would be restricted to a maximum price of $3.50/gallon and to a minimum octane level of 90. Now, Station B could lower its octane to 90, which is below the precontrol levels while continuing to sell the gasoline as premium and to charge $3.50/gallon for it. As long as consumers are willing to pay more than $3.50/gallon for premium gasoline, they are willing to pay the higher money price for B’s gasoline, provided that the time price they pay is correspondingly less than for A’s gasoline. Since the time price is spent to acquire rights from the public domain and is not transferred to anyone, there is no countervailing loss from the reduction in waiting time when buying B’s higher-price gasoline. The government’s specification of rights plays into the hands of Station B. By lowering gasoline quality without violating the regulation, it could capture some of the value of the gasoline – 25 cents per gallon – that seemed to end up in the public domain as a result of the price control. We can generalize these predictions. First, when a price control on gasoline is imposed, its quality in terms of octane levels should decline as sellers attempted to capture some of the value that was placed in the public domain. Second, the quantity of any substitutes for octane (such as antiknock additives) should increase subsequent to the imposition of the price control. Third, waiting time in the higher-price stations should be lower than in the lower-price 15

An important complication arises with regard to the mechanics of the queue. It makes a difference if gasoline is rationed by the gallon or by the tank. When gasoline is rationed by the capacity of the tank then a person with a small tank gets less gasoline for each waiting episode compared to someone whose car has a large tank. This can affect who is in the line. If there are mostly large tank cars, then the marginal waiter is likely the owner of a large tank. This drives up the waiting time, and the small tank owner my not enter, or enter at the most inconvenient times. Independent of shortages, a person can save resources (time) by filling the tank less often, and people occasionally do run out of gas by postponing purchase too long. Under price controls, people will run out of gas more often and, among automobiles running out of gas, relatively more prevalent will be those with a small driving range (per full tank). For these cars, the increase in the per-gallon cost of filling the tank is higher.

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stations; moreover, buyers in the higher-price stations should place a greater value on their time than buyers in the lower-price stations. An analysis similar to that of the octane level applies to other gasoline attributes as well as to the gas station services. No matter what specifications the regulator stipulated, whether explicit or implicit, suppliers increase profit by just meeting them, provided that before the controls were imposed these specifications were exceeded. Here, too, the reduction in quality of the product does not harm consumers, who simply spend fewer resources on acquiring the less-valued rights that were placed in the public domain. Turning to gas station services, the type and level of services that go with the purchase of gasoline vary considerably from station to station. If the price control regulation specifies nothing about the level of services to be provided then the owner response will be similar to that of the octane levels. First, wherever they could, all gas stations would reduce the level of service to the minimum possible. Second, gas stations that, prior to the price control provided high levels of service and charged for them, now have an additional margin of adjustment not available to low quality, low price stations.16 High-quality stations can reduce their service level to near zero, thereby saving on every gallon sold, and still sell gasoline for the controlled price, which enables them to avoid losing some of its wealth to the public domain. Consumers will buy all that a high-quality station can sell at the regulated price without much service so long as the cost of waiting at the low-quality station exceeds the difference in the regulated price. Gas station owners might be able to alter still other margins of their product, like station hours, without violating the letter of the regulation. Selling gasoline is more costly at midnight than during business hours because night workers must be paid a higher wage and security is more problematic then. Perhaps because complex pricing schemes are costly to operate, 24-hour stations charge the same price at all hours. The average cost of 24-hour stations is higher than that of stations open only during daytime hours; the single price charged by the former must therefore be higher than that charged by the latter. Since price controls require stations not to exceed the old price but do not require them to keep their old hours, 24-hour stations will shorten their hours of service. Such stations are able to charge prices higher than those charged by others while incurring the same costs. The model here offers an additional prediction regarding firm survival under price controls. Because some firms are less constrained than others, those with the greatest number of margins at which to adjust are expected to tolerate the price control situation longer and more completely than those with fewer margins of adjustment. Because consumers pay the same full price (i.e., time plus 16

Reasonably, convenient locations and smoothly functioning pumps are examples of services even low-service gas stations still provided. Under competition in general, if a station sells at a price higher than what it had paid for the gasoline (including transportation), some extra service must be provided.

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money) for the same product no matter where they make the purchase, and they are unconcerned about the particular mix of time and money. Thus, in the case of gasoline stations, if self-service stations have fewer margins on which to adjust to price controls, then they are more likely to go out of business – especially if they could sell their allocation to other sellers. Thus far we have considered only those margins of adjustment that are open to sellers. Other margins exist that only buyers or both buyers and sellers can adjust to further reduce the dissipation. The resources spent in a queue are received by no one, and the queues’ existence indicates that potential gains from sidestepping them exist. One common way to circumvent price controls, and thus to lower losses, is to tie the sale of a controlled good to the sale of another product not subject to price controls. In the case of gasoline, a station owner might charge more for oil changes, tire inspection, and other services so as to mask the true price of gasoline. A customer whose waiting cost for a full tank of gasoline is $35 might be willing to pay a price up to $35 above the competitive price of an oil change when offered with a full tank of gas and no waiting. The seller who makes such an offer is able to capture some of the value that otherwise would have been dissipated by waiting.17 The Minimization of Dissipation The analysis of how sellers adjust the service they offer in the shadow of price controls demonstrates two important points developed by Cheung (1974). First, price controls attenuate property rights and place some potential income in the public domain. Income is made non-exclusive, then, and resources are spent to capture it. Second, maximization implies that the parties to the controlled transaction will act so as to make the dissipation a constrained minimum. In the case considered here, resources are dissipated, but by adjusting, among other things, their levels of their service downward as the constraint of price controls became binding, sellers are able to capture a value that would otherwise have been left in the public domain. This action is a component of the minimization of dissipation. Consider the following example, illustrated in Figure 9.7: In both panels (a) and (b), S0 and D0 are the supply and demand curves for full-service, regular gasoline before the implementation of a price control, and P0 , is the original market price. Suppose a control price Pc < P0 is introduced. Panel (a) shows that with this binding control price, if sellers continue to offer full service, they would supply quantity Q1 for which consumers would be willing to pay 17

Most statements about price ceilings applies to price floors. When the state mandates a minimum wage, the neoclassical model predicts a “surplus” and transfer of wealth from firms to workers. However, at the lower level of employment, there is a difference in the minimum wage workers are willing to work at and the regulated minimum wage. The regulations place this wealth in the public domain, and again there will be competition among workers and firms to capture it based on their ability and circumstances.

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P

P S1

P1

S0

S0

S2

P0 P2 Pc

P0 Pc D0 Q0

Q1 (a)

FIGURE

Gallons/Day

D2 Q2 Q0

D0 Gallons/Day

(b)

9.7 Minimizing dissipation

P1 per gallon. Assuming homogeneous buyers, the difference between P1 and the control price would be dissipated in the form of time spent in a queue so long as no quality adjustments were made. Adding the cost of waiting to the control price means that each buyer pays the equivalent of P1 in terms of time and money, and the total value of the queuing dissipation is shown by the vertically shaded rectangle. This area is lost in the sense that the value of the customer time expenditure is received by no one. However, the seller can capture some of this dissipated income by reducing gasoline quality and associated services. Now consider panel (b) of Figure 9.7 where the station lowers the quality of service offered with the gasoline. Because gasoline sold under a price control continues to be sold by the gallon, the coordinates of Figure 9.7 have the correct units for the changed product, while the supply and demand curves for the new quality must be redrawn. S2 is the new supply of gasoline, the production of which required fewer resources per gallon because of the reduction in the quality of services. Consumer valuation of the no-service gasoline is less than that of full-service gasoline, and the new demand curve D2 falls by more than the fall in costs because that is why the services were provided to begin with. The intersection of D2 and S2 must therefore be to the left of the intersection between D0 and S0 Given the control price per gallon, the service station offers quantity Q2 no-service gasoline. At that quantity, consumers are willing to pay P2 , and the difference between this and the control price is again dissipated away. This dissipation is shown as the slanted shaded area. The dissipation per gallon was reduced to P2 − Pc , but the quantity of gasoline sold has increased compared to panel (a). The new total dissipation after service reduction (combined with the appropriate “welfare triangles”), is less than the dissipation without the service reduction.

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It may even be possible that quality could be lowered to the point where there are no lines. When the discrepancy between the market price and the control price is not “too large” the adjustment in gasoline quality can be sufficient to yield an equilibrium price that equals the control price; thus, no waiting lines emerge. Given the many margins available for adjustment, maximization means that various components of service such as windshield cleaning, tire checking, service accompanied with smiles can be eliminated. Elimination will begin with services that have the lowest value relative to cost and progress as the discrepancy between the control and the clearing price increase. Only if a price control constraint is severe will it be the case that after all seller adjustments have been made, the equilibrium price still exceeds the control price. In such a case, the quantity supplied will fall short of that demanded and queues will ensue to ration the available quantity. CONCLUSION

The foregoing analysis of rationing by waiting and of price controls has shown that due to the complexity of transactions, market participants have many margins over which they can adjust besides quantity and price. Maximization implies that such margins will be exploited, and the pattern of that exploitation is predictable. People will use the lowest-cost methods available to them under the constraints to reclaim as much as they can of the value that the regulations place in the public domain. As a result of such actions, dissipation from the regulations is minimized. In the example of gasoline price controls, adjustments can be made to provide such things as the lowest permitted octane levels, the shortest possible hours of operation for service stations, and the frequency of oil changes. The analysis of a situation in which price is controlled by the government at a level below (or, for that matter, above) the market price applies to situations controlled purely by market forces as well. The similarity lies in the fact that, with the exception of organized markets such as the stock exchange, many market-controlled prices are often kept constant in the face of constantly changing conditions. For instance, the price of coffee changes by the minute on the coffee futures exchange, and within supermarkets demand changes by the hour of the day and by the day of the week. The supermarket price of coffee, however, often stays unchanged for weeks. Therefore, not only price but other factors as well must affect the allocation. Waiting is just one such margin. The main difference between the analyses of the adjustment to governmentcontrolled prices and to unchanging market prices is the greater leeway market sellers have over the criteria by which to allocate their commodities in the non-controlled situation.

10 Forming Property Rights

INTRODUCTION

In Chapter 9, we examined instances where an owner of a commodity placed part or all of it in the public domain. We ignored the reason why such a thing was done and focused our attention on how others captured the newly unowned commodity. That is, we were concerned with the mechanics of particular capture procedures like waiting, racing, and adjusting quality. In this chapter, we want to consider when or under what circumstances will a commodity or some number of its attributes move in or out of the public domain. Many things exist in the public domain as a state of nature; that is, they may never have had an owner because it was never in anyone’s interest to establish property rights over them. The planets have been entirely unowned for human history; however, property rights over the moon and Mars are perhaps on the horizon. But for all commodities, whether their attributes are to be in or out of the public domain is a matter of choice. This choice depends on the ebb and flow of the costs and benefits of ownership. We now turn to this question of when are property rights formed, and how do they evolve under different circumstances.1 It is tempting to trace current property rights back to their point of origin to determine why these rights came about, yet such an effort would be futile. The ability to consume commodities, including those necessary to sustain life, implies the possession of economic rights over them. Had there been a time of no property rights, then there would have been no life to examine – a pre-property rights state of affairs has no meaning. Property rights (though very weak) have always existed, and one cannot discover evidence of a pre-property rights state of the world. In order to gain a toehold on the evolution of property rights, one must start with the simultaneous emergence 1

For a recent survey of the literature on emerging rights, especially within the context of political rights, see Alston and Mueller (2023).

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of life and property rights, where some rights are already in place. One must resort to something less dramatic than, but similar to, the physicist’s big bang theory. Once some rights are already in existence, it is possible to explore new formations and developments with respect to changes in economic conditions. THE MEANING OF PROPERTY RIGHT FORMATION

One of the earliest economic examinations of property rights was Frank Knight’s (1924) discussion of social cost. In his analysis of the use of roads, he demonstrated decisively the role of ownership in the allocation of resources. In a similar vein, several decades later H. Scott Gordon (1954) analyzed the common-property problem of fishing in international (public domain) waters. Even after Gordon’s contribution, however, little attention was given to the establishment and evolution of property rights. This likely stemmed from the simple characterization made by Knight and Gordon who both assumed property rights are all-or-nothing and that the good in question (roads or fishery) was one dimensional. By assuming property rights are either present and perfect or totally absent, they neglected the possibility of an intermediate state in which rights are imperfect, incomplete, and divided. That is, they neglected the possibility that some property rights might get only partially created while others do not; or that one newly created property right is held by one person and another differently created property right is held by another person; or that rights to some attributes emerge but not for other attributes. If we return to our matrix expression of a property right developed in Chapter 2, the analysis of Knight and Gordon, which has been used by so many, deals with the following transition:

J1



R1  0 , (a)

−→

J1



R1  1 (b)

There is one property right R1 , over a commodity with one attribute J1 , and it moves from having a strength of zero in state (a) to a strength of one in state (b). The usual characterization of commodities as homogeneous entities, often with only one attribute, makes it easy to conclude that commodities are either owned or not owned, and that there are no intermediate or complicated states of ownership. Such a view seems to have been bolstered by the assumption that economic rights are equal to legal rights and that the latter are either present and perfectly enforced or entirely absent. Moreover, property rights are typically assumed to be largely – perhaps entirely – created and enforced by government. Correspondingly, it has traditionally been asserted that it is the government’s fault that rights are left in the public domain and subject to

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“open access.”2 This leads to a mantra that it is the state’s duty to “define clear and strong property rights.” Knight and Gordon implied that if the government had turned roads or fisheries into private property, the associated commonproperty dissipation would have disappeared. This view is easy to accept if one believes that commodities are one-dimensional and either owned or not owned by government fiat. Within the classification of all-or-nothing ownership, the absence of ownership is often termed “common property.” Lueck (1994) has pointed out this is a misnomer – common property refers to situations where a limited number of people have restricted access to a commodity and have common shares to its output.3 This characterization is consistent with the historical meaning of the term, which originated among the English villager practice of using certain areas for collective grazing and cutting firewood. Dahlman (1980) describes this practice and makes it clear that the village common was open only to the villagers, not to outsiders, and that the villagers’ own rights were stinted.4 They could neither add livestock to the herd nor cut whatever amount of wood they wanted. On the contrary, they were allowed to place in the herd only a set number of animals, and all villagers were restricted as to the amount of wood they could cut. Whereas that land was held in common, its use was directly controlled by the villagers, partly through voting. It was certainly managed as private property among a group of individuals.5 Throughout the book we have argued that it is incorrect to think of property rights as all-or-nothing. Economic property rights are always divided, imperfect, and incomplete. Returning again to our Chapter 2 notation, the delineation of economic property rights over a commodity for a particular individual n is given by the matrix Bn : ⎛

bn11

⎜ . Bn = J ⎝ .. bnJ1

R ... bnjr ...

⎞ bn1R .. ⎟ . ⎠ bnJR

This means that some clarity is required when speaking of rights being “formed or evolved.” Property rights are formed when an attribute(s) previously in the public domain now comes partially under the control of an individual; or when a new right previously not in existence is created (and possibly multiple rights 2 3 4 5

Similarly, it is often asserted that it is the government’s duty to fully protect its citizens against theft. Lueck (1994) has pointed out that what many note as “common property” is actually “open access.” With open access there is no restriction on who can utilize what is in the public domain. See also Ostrom 1990. Dahlman supplies considerably more detail on the management of the common. Casari (2007) shows that the same sorts of restrictions managed pastures and forestry in the Swiss Alps for centuries.

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are created and held by different people); or for a given set of attributes and rights, the level of perfection moves from zero to some positive value. Implicitly, economists have assumed this latter case where strength moves from zero to one. The formation and evolution of property rights is, then, rather complicated, fluid, and nuanced. In practice, more than one margin can change at one time, and furthermore, any of these changes can be small and continuous, or they might be large and discrete. This theory of economic property rights grinds against the common view that commodities are always more valued when they are moved to single private ownership. On the contrary, it may be the case that a commodity is more valued when ownership is strengthened but also divided. A closely related view holds that the transfer of government property to private ownership will necessarily increase its value. A priori, this is not the case. Increasing ownership in any one of the three dimensions (division, completeness, perfection) is costly, and, therefore, it is not necessarily more efficient to move ownership from the public domain or government ownership to some form of more individual private ownership. Since transaction costs are positive, private ownership always comes at a cost. As long as access to, and use of, public property is subject, as it usually is, to restrictions – such as prohibition of hunting of young game animals – one cannot automatically conclude that rights would be more valued under private ownership than they are under public ownership.6 Attributes in and out of the Public Domain The case of a complex, but partially owned, commodity with multiple attributes that may or may not be left in the public domain, has to some extent, already been dealt with in previous chapters. This simplest of cases shows that private individuals choose to control or let loose various attributes based on the benefits and costs of establishing and maintaining the economic rights to those attributes. Consider the case of restaurant owners who supply their patrons with “free” salt and who, therefore, place valued salt attributes in the public domain. Patrons capture the rights to free salt by consuming it to the point at which its marginal value to them is zero. Restaurateurs price menu items high enough to cover the cost of the salt; however, they still relinquish the marginal unit of salt to the public domain, since the zero-marginal charge to patrons is less than the cost of the marginal unit. There is no law stopping restaurant owners from making marginal charges for each of their commodities’ attributes. Rather, it is the case that it does not 6

This point was made by Coase, p 9, 1960, when he noted that the costs of managing an externality either through market prices or within a firm might be so high as to be infeasible. Rather, “An alternative solution is direct government regulation. ... Thus, the government ... may,... decree that certain methods of production should or should not be used ... or may confine certain types of business to certain districts ....”

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pay to price some attributes. The costs of imposing marginal charges consist of measuring or metering and policing.7 Were the restauranteurs to charge for salt, revenues net of the cost of the salt would increase by more than the fall in the meal price. Buyers, of course, would have to pay extra for the salt they consume, but would gain more from the lower meal price. The owners, however, deem some of their rights too expensive to exercise and choose to place them in the public domain.8 Since owners cannot capture such values without incurring even greater costs, their actions are not dissipating. Even while seemingly placing such values in the public domain, owners are still able to extract some value.9 Public and Private Roads Let us now consider another example to understand how complicated the evolution of property rights can be. Imagine a large complicated asset legally owned by the state, but which has many of its attributes in the public domain, and with few available rights attached to the asset to be exercised by the state. Now imagine conditions change such that attributes are privatized, more rights are formed, and the strength of rights increases. Finally, other circumstances change and the state resumes ownership over some attributes of the asset and then places others back into the public domain. Such a transition describes the evolution of roads over the past 800 years in England.10 Roads are considered an exemplar of public provision to solve a classic market failure, but their history suggests this is not the case. In English medieval times, the “King’s Highway” was just an easement across private property; a muck path used by locals and the odd traveler. Roads, as something a modern person would even begin to recognize, did not become common until the middle of the sixteenth century when England created a system of local public parish ownership of roads, paid for by the parish, with community members required to work six days per year on maintenance. Most of the attributes of the road were in the public domain, and rights to the road in terms of excluding others, collecting tolls, and heavy use were mostly nonexistent. This public system was adequate for the small amount of foot traffic of the time in most jurisdictions. However, as towns grew and wagon traffic 7 8

9

10

An additional cost is that of convincing patrons that prices will not be raised after they enter the premises. A similar discussion is presented in Alchian and Allen (1977); see especially Chapter 5. Because of the cost of exercising rights, the policy prescription that all rights should be made private and enforced by the state is inconsistent with individual maximization and is, at best, innocuous. Salt is just one of the many “free” attributes available to restaurant patrons. Another is the opportunity to eat at rush hour while not paying the owner a differential above the non-rush hour price, and while capturing the valued rush-hour time, as a rule, by waiting or by rushing ahead of others. Patrons also do not pay, on the margin, for the amount of time they occupy space in the restaurant and for the level of commotion they create. This discussion is based on Allen (chapter 7, 2012).

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increased, these roads came under considerable disrepair. The parish had little incentive to maintain roads used by those outside its jurisdiction. In the middle of the seventeenth century a new organization was formed: the turnpike trust, a private, non-profit firm, chartered by the Crown to build, maintain, and charge for road use. It is too simple to say that “roads became private property.” Rather, with the creation of the trusts, some attributes were withdrawn from the public domain, new specific rights were created and assigned to the trust, and the ability to enforce these rights increased. There was formation on all three dimensions of the distribution of property rights. The turnpike trusts quickly evolved into private road companies, and greatly expanded the road system in England over the next 100 years. Toll gates were set up along the route and were controlled in the form of a franchise contract. A local gate-keeper paid the trust a fixed sum to control the gate, and then charged for traffic. Critically, the trust retained some property rights over the road after the toll had been paid. This took the form of restrictions on the type of traffic: the type and width of carriage wheel, the weight of loads, and the number of horses in a team. By 1838, there were 22,000 miles of turnpike roads and over 1,100 different trusts. This compared to over 15,000 parishes that controlled 106,000 miles of roads. On average, the turnpike trusts spent almost five times more on maintenance per mile than did the parishes.11 The turnpike system, however, came to an end during the nineteenth century. Various organizations that heavily used the roads demanded that roads should “accommodate the traffic, rather than the traffic accommodate the roads.”12 Ironically, the new system would be closer to the parish system of administration than to the trusts. Local geographic areas would control their own roads, levy compulsory taxes or rates, have permanent salaried professional officials, and employ wage labor. Ownership moved from private individuals back to some type of state ownership. With this, many use rights were placed back in the public domain, but others were retained by the state and strengthened. The early parish system was a form of public road provision, but it was full of medieval service requirements that were costly and the limited set of rights owned produced low quality roads, especially for wheeled traffic. The turnpike system was a form of private individual ownership that charged users prices for road services. Charging provided an incentive to build roads non-locals wanted, and road maintenance costs were mitigated by limiting the type of traffic allowed. Given that trusts maintained a monopoly along a given route, they were able to charge prices above the marginal costs of traffic and cover the costs of road construction. The two earlier systems had provided a viable solution, given the road technologies of the time, to monitor the use and abuse of the road. With the 11 12

Barker and Savage 1974, p. 120; Bogart (2005b) estimates a tenfold increase. See also Allen (2012). Webb and Webb 1963, p. 172.

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development of road science in the nineteenth century – through use of different materials, surveys, and leveling grades – standards were developed in terms of uniform methods of road bed construction, standard materials that were screened to remove dirt and other materials that affected a road’s performance, and specified road surfaces and profiles.13 The result was not only a steady improvement in carriage times between destinations, but more significantly these improvements lowered the costs of third party measurement and monitoring of road construction and use. This allowed the state, through local administrations, to monitor paid staff to build and maintain the roads. We will leave it to the next chapter to discuss why it was efficient for the state to take back ownership of the roads and then place many attributes back into the public domain and relinquish rights of exclusion and toll collection. For now, it suffices that the history of roads in England shows the complicated nature in which property rights come in and out of the public domain. The example also highlights the assumptions that underlie Knight’s (1924) analysis of private ownership of roads where the private road owners determine and collect the optimal prices and police the use of the roads at no cost. Even with modern public ownership of roads, it must be recognized that public roads are not managed as pure common property. Restrictions on the safety and size of vehicles still exist, and road users are required to pay various fees and taxes, the gasoline tax being the most significant. The gasoline tax rations road use; the higher the tax, the lower the demand for roads and the lower the level of congestion. It is, however, a rather blunt device for optimizing the congestion level. Because the tax payment is proportional to the number of gallons purchased, it fails to distinguish, for instance, between peak-hour use and off-peak use; it makes the wrong distinction, in terms of congestion costs users impose, between more and less fuel-efficient cars. However, because of the costliness of pricing and policing, market prices are subject to similar shortcomings. The history of roads shows that private ownership is not always superior to government ownership, and vice versa. Sometimes the most efficient form of ownership will be through the state. Efficiency considerations will dictate how they are used. It is expected, for instance, that as the costs of, or the gains from, monitoring public-sector attributes increase, the use of public-sector attributes will be increasingly restricted.14 DEMSETZ ON THE FORMATION OF PRIVATE PROPERTY

Demsetz (1967) is a seminal contribution to the study of property rights. He was one of the first to stress that property rights have a broader meaning than 13 14

Alberts 1972, p. 144. Lueck (1989) demonstrates that state action regarding wildlife is consistent with the hypothesis that its objective is to maximize the value of wildlife.

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legal rights, and that different patterns of property rights lead to different patterns of behavior. His paper, however, is best known for the simple idea that private property emerges when the benefits of establishing those rights exceed the costs of doing so. Demsetz’s idea appears to be self-evident: new rights are created in response to new economic forces that increase the value of the rights. According to this view, rights are a matter of economic value. Demsetz elaborated on this idea with a short history of the Montagnais Indians of Labrador. Specifically, he noted that prior to the Europeans’ arrival in Labrador, when the value of beaver pelts was low, beaver habitats were held as common property. When the European market became accessible, the value of beaver pelts increased and beaver habitats were converted to private property.15 For all of his insights, Demsetz still considered property rights as all-ornothing. Figure 10.1 captures the Demsetz idea that a good is either owned or not based on its value. The first-best value of the single attribute good is on the horizontal axis which is presumably determined by underlying demand and supply conditions. We could call this neoclassical value a “gross value” because it does not take into account the transaction costs of establishing ownership over the good. The dollar benefits and costs of ownership over the good are on the vertical axis. Assuming ownership is not shared, the benefit of property rights is given by the 45◦ line. Demsetz implicitly assumed that the costs of establishing and maintaining property rights over the good were linear and constant. In Figure 10.1 then, the cost line is the transaction cost function. The vertical distance between the two lines represents the asset’s secondbest value, which is necessarily less than the first-best value when transaction costs are positive. Demsetz’s main point was that a critical first-best value, V C , determines whether the good is owned or is in the public domain. To the left of V C , the good is in the public domain because the transaction costs exceed the benefits of ownership; therefore, wealth maximizers make no attempt to establish rights. The asset remains in the public domain and has no value. To the right of V C , a perfect economic property right exists. Given the discussion of property rights in Chapter 2, and the distinction between a specific property right and its level of strength, we can consider one slight adaptation to this model. Suppose there was a good whose gross value was just to the right of V C , but the strength of this right was, say, s = 0.25. Now suppose that the gross value of this good increased to V  . The level of property strength is a choice, and its level was discussed in Chapter 3 where we argued that the value of property right strength also increases, so does the value of the good. This means that stronger rights are associated with goods of a higher value, but this comes at a cost. The cost of increasing strength, however, must be less than the increased value of the good, otherwise, it would 15

McManus (1972) ironically shows that Demsetz misunderstood the property rights structure that the Montagnais operated under, and that they were not able to establish private property over beaver when European trade emerged. See also Carlos and Lewis (1993).

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Costs and benefits of PRs.

o

45 = Benefit

A

B

V FIGURE

c

V'

TC(s=1)

First best value of good

10.1 Forming private property

not take place. This means that as V increases, the TC function shifts up with the increased strength, but this upward shift is lower than the change in the value of the good. Figure 10.2 shows this, and also draws the optimal transaction cost function – the locus of optimal property right strengths for a given gross value. Thus, along TC∗ the level of property right strength is increasing with respect to the gross value of the single attribute good. Therefore, the extended Demsetz model makes two predictions: As the gross value of a good increases, it is more likely to become privately owned, and the strength of this ownership increases with gross value. Despite the simplicity, three critical insights emerge. First, people acquire and relinquish rights as a matter of choice. This choice to create rights occurs when the gains from such actions exceed the costs. Conversely, people relinquish rights when the gains from owning things are deemed insufficient, thus placing or leaving such things in the public domain. What is found in the public domain, therefore, is what people have chosen not to claim. As Demsetz also pointed out, when conditions change that alter a first-best value, a piece of property considered not worth owning may be newly perceived as worthwhile; conversely, what was at first owned may later be placed in the public domain.16 Second, when rights move from the public domain and into the possession of an individual, the strength of those rights might be quite low. At V C , the 16

Libecap (1989) analyzes common-pool problems in a similar vein. He focuses on the political bargaining for the legal formation of rights. See also Alston and Mueller (2023).

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190 Costs and benefits of PRs.

o

45 = Benefit

TC(s*) TC(s=.4) TC(s=.25)

V FIGURE

c

V'

First best value of good

10.2 Private property and imperfection

value of the good might be so low that strong property rights are not warranted. As the value of the good increases, the strength (perfection) of the good also increases. Finally, the critical value threshold for property right creation is positively related to transaction costs. If the transaction cost function falls, then V C also falls and more values of the good lead to ownership. This is a trivial implication of the Demsetz model, but one that has substantial empirical support.17 These applications range from water to oil rights, surfing waves to parking spaces.18 We briefly describe two applications of the basic Demsetz model. The California Gold Rush Umbeck (1977) provides a fascinating case of the formation of economic property rights during the development of the California gold fields in the middle of the nineteenth century.19 Rich deposits of gold were quietly discovered in California in 1848 when the region was under U.S. military occupation, just 17

18 19

Anderson and Hill (1975) was the first paper to examine innovations on the American frontier that lowered transaction costs. One of their examples was the invention of barbed wire, which lowered the costs of fencing the, mostly treeless, Great Plains. Hornbeck (2010) using modern empirical methods, shows there is a causal relation between the universal adoption of barbed wire in the late nineteenth century, and the amount of settlement, land improvement, productivity, and land values. The June 2002 issue of the Journal of Legal Studies is entirely devoted to the Demsetz model and applications. Much of this section is taken from Umbeck’s (1977) study.

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days before the signing of the peace treaty between the United States and Mexico. The gold-bearing land was not privately owned and initially treated as open access, although this caused little trouble given the few miners present in 1848. By 1849, word had gotten out regarding the discovery, and the rush was on. Although the U.S. government was the nominal owner of the gold-bearing land, it lacked sufficient power to enforce its ownership or maintain order. This impotence was exacerbated in that the thousands of fortune seekers who descended on the Sierra foothills to prospect for gold during this time included many members of the American military who had been stationed in California and had subsequently deserted their posts. With the rising value of gold-bearing land, and almost no initial state presence, the gold prospectors were on their own. They established claims and claiming associations, but subject to numerous constraints to collectively protect their mines. One interesting feature was the equal division of mining claims among the members of a mining group, regardless of the prospector’s mining ability. When large numbers of new miners arrived to an area, often the mines were subdivided to allow the newcomers in. The miners established property rights, but they were quite imperfect and incomplete (e.g., restrictions on how long a miner could be away from his mine). Although the process of forming rights to the gold-bearing land was not subject to much violence, it consumed substantial amounts of resources. The absence of state courts and of the known procedures under which they operated, predicting who would win any particular dispute was difficult. Weak property rights to the mines meant that information production on gold locations was insecure. Any miner who discovered gold and attracted attention would find a rush of gold seekers encroaching his claim. When the ultimate owner of a claim is uncertain, there is little information produced to begin with. This further weakened the property rights to the mine.20 Eventually the United States enacted laws regulating the private acquisition of rights to mineral land in 1866 and began to enforce them. California mines were quickly consolidated into private holdings, and large mines with wage workers emerged. Although the early miners did not operate in an institutional vacuum, the absence of legal property rights forced miners to adopt various forms of common and shared property.21 With the actual arrival of 20

21

Fifty years later, during the Klondike gold rush in the northern Yukon territory, a social norm of information sharing developed. In the Klondike, the specific location, local geography, and extreme climate came together to secure rights and strongly complement the fledgling government institutions that were there at the time. As a result, it took only a small incentive payment from the state to get miners to act in the social interest. See Allen (2007) for discussion. According to Anderson and Zerbe (2000), they were constrained by understandings of natural rights, and the expectation that the state would eventually enforce the U.S. constitution. Umbeck (1981) is careful to note that as chaotic as the gold rush was; some rights were defined all along in practice, particularly those related to human assets and to personal belongings, which included guns.

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legally enforced rights in 1866 stronger private property was established and the mines became more valuable. Converting the North Sea into Property In 1958, the Convention on the Continental Shelf was signed in Geneva (see Dam 1965). The provisions of the convention divided among the countries bordering the North Sea some of the commonly held attributes of that sea, particularly those related to minerals.22 Two factors had been working to enhance the value of the North Sea in the years preceding the agreement. First, underwater drilling, which was becoming more widespread, was declining in cost; second, various signs were emerging that the region contained natural gas and crude oil reserves.23 The countries surrounding the North Sea could conceivably have unilaterally extended their territorial rights toward the middle of the sea. Oil companies, however, were not going to invest resources in searching for oil unless they expected their potential legal ownership and, concurrently, their economic ownership of that oil to be secure. The preceding discussion suggests that the increase in value of the oil resources of the North Sea generated forces to better delineate rights over it. By reaching an agreement, the countries involved gained ownership of segments of the sea. They could then either exploit their sea rights directly or grant them to private parties and let those private concerns exploit them. Subsequent events proved that the formal agreement and the accurate delineation of borders was ultimately of great value. When the North Sea countries convened to establish rights over the sea, no one knew where oil would be found, so it was easy to arrive at a formula that would give each country the territory nearest to it without generating much dispute regarding the precise setting of borders. The formula actually selected was that any point on the sea (and on the sea bottom) belonged to the country to which the point was closest. As it turned out, many of the major oil and gas discoveries lay close to the border between the Norwegian and the United Kingdom sectors. Since the border was precisely marked, ownership of these finds was not in dispute. There is little doubt that without the agreement oil companies would not have searched in that area. The value of the clear delineation is further illustrated by the following observation. There is a deep trench in the Norwegian sector of the North Sea. Laying a pipeline across the trench is prohibitively costly. Some of the Norwegian oil deposits are on the United Kingdom side of the trench, which seems to make the United Kingdom a more natural owner of that area than Norway. Once rights were delineated, there was little difficulty in 22 23

These countries are Belgium, Denmark, France, the Netherlands, Norway, the United Kingdom, and Germany. For example, gas was discovered in the Netherlands and beneath the North Sea near the United Kingdom.

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developing the area. Indeed, some of the Norwegian oil is shipped by pipeline to the United Kingdom. DEMSETZ MODEL WITH NONLINEAR COSTS

The cases of the California gold rush and the privatization of the North Sea are both examples where ownership moved from open access to common to private property when the value of the good increased. It was also the case that in terms of perfection, the strength of existing rights increased as well. It might seem a general prediction: things valued highly, other things equal, should more likely be owned, and the strength of the property right should also be higher, but this only holds in the case where goods are simple and contain a single attribute. Umbeck (1981) pointed out that when a gross value increases the gain from theft is also higher. A priori, it appears ambiguous whether the extra policing to deter the new theft threat justifies the gains from stronger property rights. Although owners control which methods to employ for protecting their rights, thieves are also free to use whatever methods they see fit. Thus, the claim that rights will be better delineated when the returns from more accurate pricing increase may not be true. Here, we consider three responses to this problem: changes in the value of the good by removing specific attributes, collective action against thieves, and altering the completeness of property rights by placing restrictions on owners. The Optimal Set of Attributes Allen (2002) analyzes this case in some detail by simply allowing the transaction cost function to be nonlinear. The mechanics of this are quite simple and shown in Figure 10.3, where the level of property right strength continues to vary with the value of the good.24 As the gross value of the good increases, it moves out of the public domain and into private property. However, as the gross value continues to increase, the costs of maintaining the private rights increase faster, and eventually, it is more efficient to have the extremely valuable good placed back in the public domain! Unlike in the earlier case in Figure 10.1 or Figure 10.2, now there is an optimal second-best value of the good, V ∗ . Goods that are too valuable might be too costly to defend, and so the gross value of a good is reduced in order to induce an even larger fall in transaction costs. It remains the case that for low valued assets, as their first-best value exogenously increases they are likely to move from the public domain to private 24

It seems counter intuitive that the strength would continue to increase, but the TC function only states what the transaction costs are, not that an individual would actually devote such resources in equilibrium.

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194 Costs & Benefits of PRs.

TC(s*) 45o B

A

VL FIGURE

V*

V

H

First-Best Value of Good

10.3 Optimal value of good

ownership. In other words, in the neighborhood of V L in Figure 10.3 the original Demsetz prediction still holds. However, it is possible that goods with very high first-best values have transaction costs of ownership that exceed the benefits and the good reverts back to the public domain. Hence, paradoxically, in principle the public domain may contain extremely valuable (in a first-best sense) and extremely low valued goods.25 Four conditions must hold for a high valued good to be in the public domain.26 First, at high values a thief must value the good more than does the owner. Second, trade is not possible between the thief and owner. Third, protection by a third party is not economical. And Fourth, the good cannot be divided into smaller usable pieces that are worth protecting. When a good is made up of a single attribute and the transaction costs only depend on the level of first-best value, it is difficult to imagine how these conditions could exist since single attribute assets should be trivial to trade, protect, and divide. Goods, of course, are never simple one dimensional items. Goods contain multiple attributes that both vary in nature and are alterable by people. When multi-attribute goods increase in first best value, it is possible that the relative valuation of the various attributes by the thief and the owner changes. This 25

26

Lueck (2002) provides an historical example of this with the American Bison. In the early nineteenth century Bison were used for robes and hunted in the winter. Bison values increased throughout the nineteenth century due to their value in leather production. Although their value increased over time, the different use meant a different harvest month, and this increased the costs of establishing ownership. As a result, property rights to Bison were reduced over the century from common property to open access. Smith (2002).

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change in relative valuation can lead to nonlinear transaction costs. For example, the value of a good increases when the value of the individual attributes increase, but the increase in the value of the good may be due to increases in attribute values that the owner does not care much about for his particular use of the good. On the other hand, a thief may value those attributes more as the value of the good increases. This difference in valuation over different attributes lies behind the nonlinear transaction cost function because the thief is willing to spend more to capture the good than the “nominal” owner is willing to spend to protect it. When these attributes are inseparable and indivisible, they make trade, division, and third party enforcement not feasible. The result, in principle, could mean that a valuable good (in a first-best sense) ends up in the public domain. Consider the case of a large, well-known diamond, and assume that there are large fixed costs of splitting the diamond, that the costs of measuring a diamond as a fraction of its value fall as the diamond increases in value, and that the owner prefers the diamond whole rather than split. Further, assume that the gross value of the diamond is always worth more as one large diamond than the joint value of the smaller split diamonds. Under these conditions, if the costs of protecting the diamond were zero, the diamond would never be split. Unfortunately, for the owner, one of the attributes of a diamond is that it can be split into smaller diamonds. More critical, split diamonds are harder if not impossible to trace, and so this characteristic is more valuable to a thief than the legal owner. As a result, the diamond thief may be willing to spend more resources to capture the diamond than the legal owner is willing to spend protecting it as long as the diamond remains large. In this case, we end up beyond V H where the second-best value of the diamond is negative.27 Of course, rather than leaving the diamond in the public domain the diamond will be cut by the original owner. Each smaller diamond is now worth protecting and the second-best value of the diamond is maximized. However, the first-best value of the single diamond is greater than the sum of first-best values of the smaller stones. There are many examples of lowering the gross value of a good by destroying attributes mostly valued by thieves in order to raise the goods net value. The rhinoceros provides a stark and simple example. The wild rhinoceros is valued for many attributes, not the least of which is its horn. The horn is essentially made of compressed hair, similar in makeup to a human fingernail. The horn continually grows and achieves its shape from constant sharpening. Although the horn is used to decorate ceremonial dagger handles in the Middle East, its chief use is in Far Eastern medicine, where it is ground into a powder for the relief of fevers. 27

One might ask “why does the thief not purchase the diamond?” However, the thief is not the high valued user of the large diamond, he only has a comparative advantage in stealing it, which also rules out the notion of third party enforcement because the thief is willing to spend more to steal the large diamond than the original owner is willing to pay a third party to protect it.

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Generally speaking, the governments of Africa manage rhinos as a common property resource in conservation areas and on public lands. Since the 1970s, there has been an international ban on the trade of rhino horn, making it costly to develop private ranges to farm the animal. In light of the ban, a black market trade in horns has developed, which has encouraged poaching. As a consequence, rhinoceros populations have fallen over the past decades as poachers killed rhinos for their valuable horn. Given the rhinoceros’ sensitive digestive tract, movement to safer locations is not an option; however, dehorning the rhino does effectively protect the rhino. Dehorning involves drugging the rhino and sawing off the horn just above the skin line. The horn eventually grows back and the procedure is repeated every 18–24 months. Dehorning, like having fingernails cut, does not hurt the rhino, nor does it appear to seriously reduce the rhinos ability to forage, defend, or breed. Removing a rhino’s horn lowers the value of the rhino to the state. However, it eliminates the incentive of the poacher to kill rhinos, and drastically lowers the cost of state rhino ownership. The result is an increase in the net value of the rhino. Dehorning lowers the gross value of the rhino by systematically eliminating the one attribute that the thief values highly. Other examples abound. Residential urban street intersections often have flower beds or other physical interruptions that slow down traffic to deter non-resident drivers looking for a short cut. Technology companies build in “obsolescence” and faults into the software that are fixed for legitimate customers, but not for pirates who steal the technology. The Kwakiutl and other Pacific Northwest Indians, along with the British Columbia and Washington coasts, practiced potlatch ceremonies where valuable fish and other capital goods were publicly destroyed to deter neighboring bands from raiding (Johnsen 1986). And furniture located in public spheres is often ugly and uncomfortable to deter people from taking it home for private use.28 Collective Action among Owners Consider a herd of cattle. Suppose that in the absence of theft, it would generate an annual income of $100. With the threat of theft, the legal owner spends, directly and indirectly, $20 a year on protection. At a cost of $5 a year, however, thieves are able to steal $10 a year’s worth of cattle. Given his $10 a year loss to theft and $20 protection cost, the owner’s net annual income is $70. The total social net income the herd of cattle generates is $75, of which the legal owner owns $70, thieves own $5, and $25 are lost. Suppose that the market price of beef goes up and the potential net annual income from the herd is now $200. As just noted, it may not be the case that the legal owner’s net income doubles. At the higher value, thieves might band together in an organized gang and steal the entire herd. The legal owner’s net income could drop to zero. 28

See Allen 2002, for more examples.

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If the removal of cattle attributes especially valued by thieves is not available, and if there is no means by which private protection of the cattle can be increased in a cost effective way, there remains one other option to the legal owner. Presumably, there are other cattlemen, and the increase in the value of beef increases the aggregate gains from cooperation among them. As a group, they may be able to form a cooperative or association that might act to patrol territory, coordinate and enforce branding, restrict access to range lands, and create posses to hunt down cattle thieves. In other words, an organization or even an institution may arise that lowers the transaction cost function and allows strong individual economic property rights to emerge. They may also try to pay off the thieves. If the cattle thieves were members of nomadic tribes or transients, an increase in the value of the cattle might mean it pays the owners to subsidize their settlement in a faraway place. This solution implicitly reallocates rights to some of the economic value of the cattle to the thieves. In the process, the formation of rights over the cattle indirectly becomes clearer, and the gains from theft are lowered. The success of such methods, however, requires a supply of thieves that is not very elastic. Similar is the case where a store’s merchandise is stolen mostly by employees. When the value of the merchandise goes up, the gains from cooperation between store owners and employees increase, and employees are expected to be made fuller residual claimants to the income they help generate. This may be achieved by changing their status to part owners by using commissions as rewards. Property Right Completeness: Water A final means by which the problem of excessive enforcement costs can be mitigated is to alter possession over specific property rights to the good in question; that is, change the completeness of property rights. Completeness refers to the collection of rights a given owner possesses: rights of exclusion, use, transfer, and income generation. As an asset becomes more valuable, these individual property rights are expected to become better defined and more clearly distinguished or delineated across the various divided owners of the complex asset. Since some individuals may be better at protecting specific rights, the good remains out of the public domain.29 An important example of this is found in the two distinct legal doctrines that govern the use of water in the United States. The eastern states use a riparian system that originated in English common law and which permits 29

Or it might be the case that only a specific right is removed and a limited amount of the good enters the public domain. McManus (1972, pp. 51–52), in his discussion of Indians on the east coast of Canada during the fur trade, noted that the Native Americans had a “Good Samaritan” rule, such that in times of famine when the value of food was extreme, neighboring tribes were allowed to encroach on hunting areas that normally would have been exclusive territory. By placing some wild game in the public domain during the famine, the cost of enforcing rights to the remaining game were reduced.

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landowners reasonable use of unspecified volumes of water from rivers and streams that run by or through their properties. Riparian systems are used in regions where water is relatively abundant and low valued at the margin, as in England and the American coasts. Within the riparian system, the property rights to water are quite incomplete and mostly limited to downstream users protected from harm by upstream users. This essentially requires the owner of the land adjacent to the river to allow any used water to drain back into the source after it has been extracted and used. Other rights to the water do not exist and so the land owner’s property rights over the water are quite incomplete.30 In contrast, many of the western states in the Great Plains are arid, and the prevailing legal system of water rights is prior appropriation. These systems arose in the late nineteenth century, and they grant individuals more types of rights to water and are therefore more complete.31 With prior appropriation, water rights are assigned to a specific volume of surface water on a firstpossession basis, and these rights include the right of transferring water away from the stream it was taken. The flow of water in western streams varies significantly both seasonally and annually. Those who established rights to water first (senior claims) have priority in their use of water over later claimants (junior claims), even if these later claimants are upstream. In times of drought, the senior claims are stronger and this allows an increase in the completeness of water rights for these holders. That is, the types of choices available for the use of the water increased for senior claimants, including the right to sell water to other locations.32 Analogous to the Demsetz prediction on the strength of rights, as the value of water increased from wet to arid regions the completeness of property rights to water also increased. Because the rights to water are often split across different individuals, there are opportunities for one type of owner to infringe on the rights of others. A special characteristic of water is that its downstream abundance and quality depends on how individuals upstream use it. When individuals with greater seniority divert less water back into the stream, the portion of water for use downstream is reduced. One person’s realized right to water, therefore, depends on the actions others take in exercising their own rights. Specific rights 30 31

32

Rose (1990) analyzes changes within the riparian system brought about primarily by the emergence of large-scale use of water for power for which previous rights were not well defined. Anderson and Hill (1975), among the first to analyze property rights, point out the reasons for why riparian were inadequate for the arid west. Miller (1985) also examined the question, but Leonard and Libecap (2019) push this analysis furtherest. The latter claims that prior appropriation, by defining more rights to water, solved a collective action problem for investing in large scale irrigation. The amount of water originally granted to individuals was in accord with the amount actually used in their operations, usually farming. As the value of water in other uses has increased (such as urban uses), the assignment of rights based on historical use becomes more costly. It is expected that prior appropriative rights are likely to evolve in the near future as these other values continue to increase.

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to water then often have restrictions attached to mitigate this transaction cost problem. The most severe restrictions on water owners in the western states regulate water use and prohibit owners from using water for any purpose other than the one it originally served. Furthermore, owners of rights to water are mostly not allowed to sell them unless the sale includes the land where the water is used, and they are not even free to use the water on their own properties in any way they wish. Were measurement costless, individuals would presumably be granted rights to remove a certain net amount of water from a stream. A person with a right to a net amount of 100 acre-feet of water could, for instance, withdraw 250 acre-feet to irrigate a crop if it was clear that 150 acre-feet would seep back into the stream. Measurement, however, is not costless; it is much cheaper to measure the amount of water removed from a stream than it is to measure the amount seeped back by return flow. Similar considerations apply to other attributes of water. It is easier to measure attributes such as salinity and temperature for the water withdrawn from a river than it is to measure the same attributes for the water in the return flow.33 The original owners of water rights to a given stream presumably used the water for a specific purpose, for example, to irrigate an orchard. The precise contents of the grant of a junior-priority right is a function of what the seniorpriority holders are allowed to do. People with rights to withdraw water from a stream who are restricted to a specific use have incomplete property rights, and are consequently less valuable than they would be in the absence of the restriction. The reciprocal nature of incomplete rights of senior owners, however, is that the rights of junior owners are more complete. Overall, the property rights to the two groups combined are more complete. In other words, whereas the rights of people with senior priorities are restricted, the rights of those with lower priorities are thereby extended. That is, although the property rights to water are incomplete from the perspective of one owner, they are (more) complete from the perspective of all owners. The more completely rights are delineated, the more they are valued, since transaction costs are reduced. That restrictions on water use increase the value of water rights explains two practices. The first regards the inter-organization transfer of water. Mutual ditch companies and irrigation districts are permitted to use water ways that seem to evade the regulation of water transfer. These organizations of neighbors are permitted to combine the water rights of their members. The 33

Because it is easier to measure the volume of water than it is to measure some of its other attributes, it is relatively easy to see that a reduction by one owner of the amount of water returned to the stream will not reduce the amount of water available to higher-priority owners even if they are located farther downstream than the lower-priority users. But a reduction in the quality of returned water will tend to reduce the water quality available to all those downstream, regardless of their priority. This implies that, priorities remaining constant, the value of the right to water in a given stream is likely to decline the farther downstream it is.

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restriction on transfers within each organization is avoided, enabling members to improve the allocation of water among themselves. Provided that the pattern of water use is not altered, the return quantity (and quality) of the water is likewise not altered. The greater flexibility available to these organizations, then, does not significantly impinge on the rights of others not part of the ditch company. Allowing water transfer within ditch companies and within irrigation districts is therefore consistent with the explanation that the purpose of the more general constraint on transfers is to enhance the delineation of property rights across independent individuals. The second practice concerns a distinct constraint in New Mexico. In that state, water rights are defined in terms of consumption, that is, the net amount of water retained by the owner. Among the western states, New Mexico is one of the most arid regions, and it consequently values its water highly, so it is not surprising that it finds the costs of the added measurement that consumption rights entail to be worthwhile. The relative ease with which owners of water rights in New Mexico may obtain the regulator’s permission to sell water is consistent with the interpretation that constraints play a role in better delineating rights across individuals.34 DISPUTES AND THE FORMATION OF RIGHTS

Owners of commodities may choose to retain them or to exchange them. Exchange is subject to agreements, and so it may be puzzling that disputes over ownership erupt at all. A preliminary discussion of the effects of changes in conditions where rights are imperfect and incomplete will reveal what causes disputes and how they are settled. As discussed, commodity owners decide whether or not to place attributes in the public domain, including within the context of an exchange. When owning an attribute becomes preferable to placing it in the public domain, the commodity owner will make the appropriate contract changes at contract-renewal time. However, an attribute that is in the public domain while the old contract is still in force can be claimed only by spending resources. Suppose theater owners price all seats equally one week and then adopt a more detailed pricing scheme the next; they are free to alter which rights they retain and which they relinquish, because they continue to own the asset. The sale of theater tickets constitutes a rental contract of space in theaters, and owners can form new contracts as older ones expire. When, for some reason, theatre tickets increase in value, the status of seats sold under the old price is clear. The advertising of particular pricing schemes for specific durations 34

New Mexico also extended prior appropriation to subsurface water as well. Johnson, Gisser, and Werner (1981) discuss water rights in New Mexico in a similar vein. In a study of water rights in four western states, Gisser (1995) elaborates on the analysis offered here. He demonstrates a strong trend toward a clearer delineation of rights to water in New Mexico and a fitful trend in Arizona, California, and Texas.

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is part of the contract between an owner and patrons. There is no dispute here between owners and patrons; any breach of contract aside, during the advertised period the rights to tickets at the old price are relinquished by the owners. These rights are not relinquished, however, to particular individuals. Since the value of the seats is higher than it was before, competition among patrons for these seats will intensify. When the value of the seats is higher, the gain from avoiding such resource-consuming competition is also higher; since these rights are already in the public domain, it is not necessarily possible to avoid competing for them. Disputes may occur in these cases where the contracts between parties simply fail to spell out stipulations to attributes that seemed to be of little value at contract time but whose value increases before the contract expires. Consider a landowner who rents out a piece of land with a deserted wooden fence on it. Suppose that at contract time the fence, which is not sufficiently valued to be explicitly mentioned in the contract, is simply ignored. Suppose, moreover, that while the contract is in effect, a highly valuable use for the fence lumber is discovered. Because rights to the fence are not well defined, a conflict regarding its ownership may erupt. Regarding the capture of the rights placed in the public domain, whatever the criteria are for capture, individuals will meet them as long as the gains from doing so exceed the costs. These criteria are set to fit the particulars of the situation. In the case of the fixed-rent tenant whose contract does not constrain the extraction level of soil nutrients, the criterion is the appropriate method and intensity of cultivation; in that of the single-price movie theater, the criterion is time. These criteria, however, do not necessarily remain intact when the gains from capture increase. In particular, parties who initially only implicitly relinquish rights to an attribute to the public domain may claim that they retain partial or complete rights to the attribute and may attempt to compete with their transacting partners in recapturing the relinquished rights. In the case of a contract that does not clearly assign some rights whose value has increased, a conflict may emerge. In these contracts, the owners of assets relinquish to their exchange partners subsets of their rights to the assets. The initial owners, whose actions (or, more likely, inaction) have implied that they have relinquished rights to an attribute, may now contend that these rights are their own, but their transacting partners may make the same claim. These considerations apply most clearly when the parties operate explicitly under contract; they may also apply to informal contracts and to relationships such as those between neighbors. Consider neighbors who possess a hedge that separates their properties. Initially, they may have elected, at least in practice, to leave the hedge in the public domain. Changes may induce them to attempt to capture some attribute of the hedge, however. For example, a rare bird may have built a nest there. Here, too, a dispute may emerge as the value of property previously placed in the public domain increases.

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The transactors considered here are operating under a contract, possibly an implicit one. One issue for them to consider is how the court might allocate the disputed rights and what costs they would incur in the attempt to influence these decisions. The parties will compare their predictions of court decisions and of the associated legal costs with those of such other methods of settling their disputes as arbitration or entirely private settlement, and they will select in each case the method they perceive as generating the highest net gain. It is true that the would-be plaintiff in a court case has the power to force the court’s resolution of a dispute. When a dispute is actually settled out of court, it is because a would-be plaintiff has perceived this alternative to be of a lower cost than settling in court. The other disputant, however, may provide compensation, perhaps in the form of concessions, so that the method of settlement involving the lowest total cost (including the costs of negotiating the compensation) will be selected. COURTS AND THE FORMATION OF RIGHTS

The courts participate in rights formation in two ways. The first is indirect: When the parties choose to settle their disputes without resorting to the courts, their actions are influenced by their perceptions of how the courts would have acted in their dispute. The second is direct: The disputes are actually settled by the courts. The balance of this section considers the second component of rights delineation. In countries operating at least in part under common law, such as the United States, Canada, and England, common-law court rulings serve as precedents for new rulings. Since the courts serve to resolve disputes, when private disputes end in common-law courts, the resolution of the particular disputes contributes to the production of a public good, namely, the assignment of legal rights in situations similar to the one litigated. Because court rulings become precedents for similar cases, litigants are also resolving others’ disputes.35 Private contractors play several indirect but crucial roles that complement those of the court. One role relates to the gains that result from anticipating and avoiding disputes. Because disputes and litigation are costly, contractors gain if their contracts anticipate potential trouble spots and provide for them. When such contracts do nevertheless reach the courts, court rulings are likely to define legal rights clearly because they are dealing with carefully crafted contracts. This effect is enhanced by forces of selectivity, which partially determine which disputes will be litigated. Focusing on the case where parties litigate for direct (mostly financial) gains only, disputants go to court only if they

35

Private rights are constrained by both common and statutory law. We do not discuss the forces that affect statutory law, since that would require an analysis of legislative behavior beyond the scope of the present work.

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are optimistic about the outcome.36 Indeed, between them they must err in the direction of excessive optimism. A court ruling that is expected to be too ambiguous to truly settle a dispute deters the parties from litigating. Only if disputants expect a ruling that will clearly define legal rights, thus incurring a few added future transaction costs, will they litigate. Among all potential litigants in a given class of disputes, self-selection will bring out the actual litigants who expect a ruling that will clearly define legal rights that had previously been in dispute. Private contracts affect the specification of rights in at least one more way. As conditions change, contract stipulations that had been attractive in the past may cease to be useful. Since the common law tends to absorb features that recur in private contracts, it is likely to have incorporated features deemed attractive in the past. The courts are expected to rule accordingly in litigation where the parties have failed to stipulate on various features of their transactions and have therefore implicitly accepted the common-law stipulations. When writing new contracts, however, contractors may explicitly stipulate whatever they wish; as long as the stipulations are not in conflict with basic principles of the law, the courts will respect the new stipulations. As new stipulations are written into contracts, the common law becomes exposed to them, tends to take them into account, and gradually replaces the old, less desirable stipulations with the preferred, newer ones. The common law is continually revised in the direction deemed desirable by private parties. CONCLUSION

By their own actions, individuals are able to control and to affect the property rights over “their” property. Individuals will exercise such control as part of their maximizing process. Whenever individuals find the existing distribution of rights to be unsatisfactory, they will alter it until they are satisfied and this alteration can mean a change in division, completeness, or perfection. In the same sense that individuals are always in equilibrium with regard to their asset holdings, they are also in equilibrium with regard to their rights over their assets. At any given moment, their rights are defined such that they do not wish to change them. Economic conditions, however, are constantly changing, and with them, the equilibrium property-rights distribution changes as well. As commodities possessed by individuals become more valuable, the individuals will own more of that commodities attributes, will possess more rights over them, and have stronger rights in general. As the value of rights to commodities that lie in the public domain increases, people will tend to spend more resources to capture them and to turn them into private property. Such transfer from the public 36

Landes (1971) was apparently the first to argue that disputes result from errors of excess optimism. Priest (1980) applied the notion to the decision to litigate, and Priest and Klein (1984) conclusively demonstrated the effect empirically.

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domain to private ownership is effected by individuals, groups, organizations, and the state. When the costs of metering and of policing assets or assets’ attributes exceed the valuations, such assets or attributes will be relinquished into the public domain and become common property. Such common property is property people choose not to own. Government property in general is valued, and its use is constrained; as a rule, it is not common property. When the value of rights to those commodities that are in the process of being exchanged increases, disputes between the exchange parties may erupt. The resolution of disputes results in the articulation of legal rights that enhance the existing economic property rights. The courts participate in the delineation of disputed rights, and the common-law courts interact with individuals in such determinations. Individuals choose whether or not to go to a common-law court, and they will litigate new cases until rights become, in their perception, well defined.

11 Benefits of the Public Domain

INTRODUCTION

Several times in the past chapters, we noted that placing attributes within the public domain can be an optimizing choice by the commodity owner when these attributes are too costly to protect and to justify maintaining economic rights over them. However, we alluded to a few cases where something else might drive the placement of goods into the public domain. When goods are placed in the public domain; especially ones that are not particularly hard to privately police, others will attempt to capture them. The method by which capture takes place may have value to the original owner of the good. For example, one form of capture is to wait in a line and allocate the valuable good placed in the public domain through time. The line is a public event and might act as a form of advertisement; hence, retailers may have “giveaways” in order to attract attention. In Cheung’s case of the underpriced high-quality theater seats, the ones who rush to capture this gain occupy the seat, and lower the costs of staffing to police interlopers who might otherwise take them. The act of “occupation” has value to the theater owner. In the discussion of public and private roads, we noted that in England roads went from being locally and publicly owned, to privately owned, and then back to public ownership with many of the road attributes placed back into the public domain. The state had no comparative advantage in road construction, but this disadvantage diminished greatly in the nineteenth century. Still, why should the state provide roads in such a manner? The social problem with the turnpike trusts was that they charged a price above marginal costs for road services. The marginal cost of road use was close to zero, and so once a road was built providing it for free would have been beneficial. It was socially beneficial to place roads in the public domain and pay for them through general rates. Historically, this had not been possible, due to the inability to build and maintain them without enormous transaction costs. 205

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Once modern methods allowed for third-party supervision of road construction, the state took over the roads. By the end of the nineteenth century, the process was complete.1 In this chapter, we examine perhaps the two greatest episodes of placing assets in the public domain: the nineteenth century railroad land grant; and homestead land grants. Placing assets in the public domain means resources are devoted to capturing them. Given the size of these grants, some have argued that they amounted to the largest peacetime waste of resources in human history. THE LAND GRANTS

The State of the American Frontier: 1776–1862 Before 1776, all land in the colonial United States was initially property of the British crown. The British authorities employed various methods of dispensing land, including granting it to states, trading companies, and individuals who crossed the Atlantic. The transfer of power that came with the revolution of 1776 redefined the thirteen state boundaries to (mostly) their current borders, and left these states in possession of their lands. The federal government took possession of lands previously claimed by the colonies, and these lands mostly went up to the Mississippi river. The size of federal lands quickly changed as the federal government acquired massive amounts throughout the first half of the nineteenth century. Most of these lands came through purchase from European powers: the Louisiana Purchase (1803, 500 million acres), the Florida purchase (1819, 43 million acres), and the Gadsden purchase (1853, 19 million acres). Texas was annexed in 1845 but none of these 200 million acres came under federal control. The Mexican-American war, settled in 1848, brought 334 million acres to the U.S., including all of California. Finally, the Oregon territory was settled diplomatically with Britain in 1846, and eventually brought the Pacific Northwest into the Union. By the middle of the nineteenth century, the area known as the lower 48 states, was legally claimed by the United States. The problem faced by the U.S. federal government was: What to do with all of this land when much of it was held, claimed, or threatened by others? Despite the claim of legal authority to the newly acquired lands, in practice U.S. sovereignty was tenuous due to threats from Native Americans, foreign powers, and the Confederacy. The economic property rights to the west were very weak.

1

Currently, in many urban centers road congestion, combined with modern methods of charging tolls electronically, has led to road attributes being removed from the public domain and priced once more.

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Confrontations with Native Americans escalated dramatically over the midnineteenth century, and this was exacerbated by steady movement of miners, Mormon and other settlers, the relocation of eastern Native American tribes into the West, the lack of a federal military presence, the forced movement and concentration of western tribes onto reserves, the inability of many tribes to effectively enter common-law treaties, corruption among federal land agents, and the constant encroachment of squatters. The sudden transformation of native life over a couple decades led to violent confrontations that could not feasibly be dealt with militarily.2 Added to this were foreign threats. There were border disputes with Britain and France, both of which made diplomatic overtures to aid Texas, California, and even the Confederacy.3 At various times, there were threats from Mexico, Spain, and even Russia. The impact of the Civil War on the Union’s rights to the West cannot be underestimated. In 1862, victory was uncertain, and the South also claimed the West. The issue of securing economic rights to the West was a matter of tremendous urgency in Washington. From the forming of the Republic and throughout the early part of the nineteenth century, the federal government aggressively pursued a policy of public land sales. This helped with federal debt and created some settlement. By 1850, however, few settlers were willing to pay for land on the frontier near or beyond the Mississippi given the tenuous property rights such a purchase entailed. Beyond the internal and external threats, there was the problem of finance, and certainly after the war and the disbanding of the army, the federal government was in no real position to effectively police the West. Most of the 1.2 billion acres of federal public land was outside of the control of the U.S. government and federal ownership was in name only. The Homestead Act and Railroad Acts In the midst of the Civil War, the 37th Congress passed a series of monumental legislations, including the first transcontinental railroad land grant act and the Homestead Act (both in 1862).4 Each placed massive amounts of federal land into the public domain, to be claimed by the first takers. The Homestead Act allocated a quarter-section (160 acres) of unappropriated public land based on first possession (first-come, first served), after the land had been federally surveyed and made available for homesteading. Only citizens who had “... never borne arms against the United States Government ...” were eligible, and once claimed, a ten-dollar registration fee was paid, an affidavit of “allegiance to the Government” was sworn, and the homesteader was to remain on the 2 3 4

Nichols (2013, pp. 127–128); White (1991, pp. 85–92); Utley (1984, p. 3); Anderson and McChesney, p. 58, 1994; and Axelrod (1993, pp. 155–156). Axelrod 1993, p. 155. Homesteading is well studied by economists. See Southey (1978), Anderson and Hill (1983, 1990), Stroup (1988), Allen (1991b, 2017), Allen and Leonard (2021).

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land, build a house, and cultivate the land for five years before title was transferred. There were many variants of the original homestead act, but throughout the homestead era from 1862 to 1934, the vast majority of homesteads were made under the original legislation. All told, lands amounting to the size of the states of California and Texas were given away to approximately 1.8 million homesteaders. Transcontinental railroad land grants were also “free” lands given to the first railroad to accept them. Unlike homesteads, these grants only lasted a short time, and 70 percent of them were handed out in just four years (1862– 1866). In total, seven railway systems acquired about eighty grants that were the equivalent in size to the area of Texas. Railroad grants came in all sorts of variations, but there were several key features. Land was given in alternate sections on either side of the track for six to forty miles, creating a wide swath of checkerboard private railroad holdings through a state or territory. In most cases, twenty miles of track had to be completed before the land was inspected, patented, and the deeds transferred. The railroad was required to complete the track within a given time period. The key feature of both types of grants was that they placed federal lands in the public domain to be captured through racing. The first homesteader to file a claim or first railroad to accept the grant, was given land at zero cost per acre. The federal government had one policy instrument for each policy. The survey requirement for homesteads meant that the state could direct where settlement would take place, and therefore, the location of homesteading was, in principle, a state choice. With railroad grants, the state could adjust the number of acres given away and therefore induce more racing if it wanted. We have already examined the racing equilibrium in Chapter 9, and so here we will use a framework based on Anderson and Hill (1990) to see the effect of adding a railroad to free homestead land. Assume that the yearly net value of land increases over time (t) and depends on whether a railroad is present or not. This net value equals v(t, Rt (l)), where l is the size of the railroad land grant, and Rt equals 0 or 1 depending on whether a railroad is present or not. In Figure 11.1 v(t, 0) shows the net value of a specific quarter-section of land on the frontier over time without a railroad present. The land becomes profitable to occupy and put into production at time t1 , and if the land had been purchased this is when the owner would show up to begin production. However, when the land is acquired by first possession, competition among racing homesteaders forces arrival time to t2 , where the present net value of the land equals zero. That is, for the marginal homesteader, the value of land in the public domain is fully dissipated through racing and early arrival. The value function v(t, 1) shows the net value of the same land when there is a railroad close by. A railroad raises the value of land because it gives access to markets and raises the value of production. Without any homesteading, a private land owner would arrive and start production at time t3 , based on the graph. With the railroad and homesteading arrival is at time t4 , where once

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v(t) v(t,1) t4

t3

t2

v(t, 0)

t1

Year

FIGURE

11.1 Homesteader arrival, with/without railroad arrival

again the present net value of the land equals zero. Quite intuitively, by increasing the value of the land, the railroad induces even more racing and therefore increases the total amount of wealth dissipated. Railroad and homestead land grants were complementary methods of rushing occupation of the West. WHY GIVE AWAY LAND ?

The Nobel Prize-winning economic historian Robert Fogel has said of the railroad grants “the federal government gave an empire of land to promoters who promised to build railroads across the sparsely settled territory of the West.”5 Why would the state want to place, not just one empire, but two in the public domain? An argument that has been put forth is that it allowed the federal government to establish actual economic property rights over a frontier it only had a disputed legal claim to.6 In 1862, it was imperative to the North to not only occupy the western lands but to make certain they were occupied by northerners loyal to the Union. Occupation, especially when fast and dense, greatly hindered the ability of Native Americans to defend their territory and also preempted Southerners from taking it. When American settlers trickled out onto the frontier, they necessarily came into conflict with the western tribes and violence erupted. In the mid-nineteenth century, the federal government was in no position to police the frontier or maintain order through force. By rushing density to an area, the level of total violence fell because the loss of hunting territory forced Native Americans to move, their reduced numbers were insufficient to launch any reasonable defense, and the new homestead arrivals were given strong incentives to self-defend the land. Homesteading, then, acted as a substitute for military expenditures on the part of the state. Homesteading also complemented the federal governments mid-nineteenth century treaty policy with Native Americans. This policy centered around the 5 6

Fogel 1964, p. 3. The first version of this argument was Barzel (1989), which was elaborated on in Allen (1991).

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creation of large Native territories. Many of these were concentrated in Montana, the Dakotas, the Indian Territory (now Oklahoma), and other parts of the southwest. By strategically locating railroads and homesteaders, the federal government was able to push Native Americans onto reserve and treaty lands, which allowed for more settlement in the remaining areas through land sales. With just homesteading, there was little incentive to move to the frontier in 1862, and estimates suggest this would have led to western settlement in the 1880s.7 Too late given the context of the Civil War. Railroad grants were used to raise the stakes and induce a much faster occupation. The railroad grants were very successful. They not only induced a transcontinental railroad to be put in place by 1869, but any specific grant initiated an immediate rush of homesteaders along the expected track and surrounding area. RESTRICTIONS ON LAND GRANTS

The benefits to the federal government of land grants was to induce occupation in order to establish economic property rights. The U.S. did this in a way that minimized the dissipation caused by racing, and placed restrictions on grants that enhanced their objective. That is, they transferred incomplete property rights to the railroads, and these efforts prevented the frontier from becoming fully common property. Restrictions on Homesteads Homesteading lore would suggest that the entire western frontier was open for homesteading, but this was far from true. All told, close to thirty percent of western public lands were homesteaded. Large blocks of land were unavailable for homesteading and lands within certain distances of railroads were either restricted or not allowed for homesteading. Other things equal, homestead lands were often of lower quality than lands sold. Due to the racing dissipation, homesteading was a costly form of establishing rights, and so it was sensible to limit its application. Homesteading placed restrictions on settlers. They were available only on surveyed lands of 160 acres, and settlers were required to remain on the land for five years, make improvements in terms of land clearing and buildings, and begin farming. Use of the survey is allowed for controlled settlement with reduced border disputes with other settlers. Restricting plots to 160 acres,

7

Fogel states it best in noting that “premature” means that no private rail enterprise was willing to take on such a project in the 1860s: ... the measuring rod of its [a railroad’s] maturity and practicability was the willingness of unaided private enterprise, guided solely by the search for profits, to undertake the project. ... The first Pacific railroad was premature not only ... in 1845 but also when the actual construction was launched after the passage of the Acts of 1862 and 1864. (Fogel 1960, p. 18)

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which was a binding constraint in the arid west, increased population density.8 Since improvements and land clearing were sunk investments if the region was lost, they provided an incentive to self-defend the homestead, and mandated residency meant that there was always a population of settlers in the area to make a viable defense. Restrictions on Railroad Grants An interesting restriction on railroad grants was that lands were given out in alternating sections of 640 acres, and then sold in quarter-sections. Constraining the grants to alternating sections lowered the value of the land subsidy and meant that the government had to give out more total lands to induce a railroad to build. However, had the federal government given out contiguous tracts of land, the land could have been sold for non-farming uses: ranching, mineral, timber, or industrial. Such uses would have resulted in low population density and not solved the state problem of establishing sovereignty over the areas. Forcing the sale of noncontiguous lots meant the land could only be used for farming. This was reinforced by the “homestead” clause in each grant that lands had to be sold to “actual settlers.” Lands sold to “speculators,” individuals who would not live on the land was discouraged. Railroads could not be paid for construction until a given amount of track was completed and inspected (patented). This naturally led to conflicts between the railroad and the federal government, but it removed the incentive for the railroad to delay construction until enough settlement took place to make the railroad more profitable. To further curtail this, every railroad grant came with a time limit for construction to be completed. Failure to meet the time limit could mean the loss of the grant. Finally, when different railways constructed different parts of the line, no location was fixed for where they would join – inducing a rush to build. For example, with the first transcontinental line, the Union Pacific started in Omaha and rushed west, while the Central Pacific rushed from Sacramento east. They met in Utah at Promontory Summit in 1869. All of these restrictions induced fast construction of the rail lines. An interesting feature of both homestead and railroad grants was in how they handled squatters, better known as preempters. Preemption was the practice of settlers moving ahead of the survey and settling regions on their own. Although this caused problems with the survey when it later came through, squatters interfered with treaty negotiations and implementation and were not subject to the directions – the federal government wanted settlement to take place. Preemption rights did exist, however, and when townships or railroads came upon these settlers, they were allowed to remain and could either 8

The vast majority of homesteads were given out under the 160-acre restrictions. In the early twentieth century some modified homesteads were allow in desert areas with larger allotments of 640 acres.

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purchase or homestead the land. What ultimately mattered to the state was occupation. It preferred to have managed occupation, but even squatters fulfilled the goal of establishing economic property rights, and so were allowed to remain. OTHER EVIDENCE

Complementary Grants Allen (2019) provides ample evidence, using the actual homestead records, that railroads and homesteads were used in a complementary fashion. When railroad grants were announced, homesteaders immediately started moving into areas along the route, and many ended up within the railroad lands where, officially, they were not supposed to locate. Rather than be removed, they were allowed to stay. Although homesteading took place close to the land grant railroads, when subsequent trunk lines followed, homesteading was discouraged near these. Trunk lines were privately built lines that were profitable because there was enough local settlement to support them. Given the existence of settlement, there was no need to dissipate land values through more homesteading. Furthermore, homesteading moved across the frontier like a wave; in the mid-west, it started around the Mississippi river and moved west. More interesting, land sales to private individuals followed. Prior to homesteading, massive efforts to sell land on the frontier had failed. Once economic property rights to the land had been established by the federal government through homesteading, the land became valuable to Americans and land sales took place. Thus, homesteading always preceded land sales in both time and space. State Cases Different U.S. states had different experiences and histories of settlement, and therefore have predictable different experiences of homesteading and rail grants. Some states, like California and Utah, had significant numbers of American settlers already due to migrations of miners and Mormons. These states generally had less homesteading. Other states, like Alaska and Maine, did not have internal or external threats to U.S. claims of authority, and as predicted, little to no homesteading took place in these states. Two states, in particular have interesting exogenous histories that are dramatically consistent with the theory of establishing rights through occupation: Texas and Oklahoma. Texas was originally a Spanish territory that became part of Mexico in 1810. Mexico was another fragile country, and aware of U.S. expansion westward. It developed a type of land grant called the empresario system, which assigned large land plots to foreigners if they could recruit other families to settle within the area, make improvements, become Mexican citizens, and convert

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to Catholicism. For every family brought to the colony, the empresario was given title to various amounts of land within the colony. Many Americans, like Steven Austin, took up the grants, and by 1836 the larger Anglo-American settlers ousted the Mexican authority and formed the Republic of Texas. The new republic now faced the same problem: a legal claim of a vast territory with little power or population to support any economic rights to the land. The new government passed a series of laws to attract new settlers, that gave out very large tracts of land and allowed settlers to locate wherever they wanted. All of the grants failed because they never created the density required to defend the territory, and settlers tended to locate in the safest locations. Texas was annexed into the U.S. in 1846. Texas, not having entered the Union as a territory, retained control over its public lands and their disposal. This meant the federal government was unable to use homesteading to complement military enforcement efforts. On the other hand, defending Texas against internal and external threats was the sole responsibility of the federal government after 1846 – not of Texas. After 1846 Texas gave no free lands out to settlers. Homesteading was a costly form of establishing economic property rights to the frontier. Given that the federal government was required to defend Texas, there was no longer an incentive for Texas to use such a policy.9 Oklahoma’s unique history provides another natural experiment of homesteading. Oklahoma was originally a quasi-sovereign “Indian Territory,” established by President Jackson who “exchanged” it for the southern lands of the “Five Civilized Tribes,” who reluctantly surrendered lands in the South and marched west along the “Trail of Tears.”10 Throughout the 1860s, other tribes were relocated to the territory as settlers moved west. Over the last decades of the nineteenth century, as other surrounding states became settled, the unoccupied lands in the western half of the Indian Territory were continuously encroached by squatters, ranchers, and various outlaws. Confrontations between whites and the various tribes continued to increase throughout the 1870s–1880s. In the 1880s several acts of Congress forced the thirty tribes then living in the territory to accept individual land plots and transfer the mostly unoccupied western lands of the territory back to the U.S. This gave the federal government legal title to the western part of the territory, but it was clearly a case of tenuous ownership given the forced transfer, ongoing western hostilities, and potential for conflict with the tribes. Once again, the solution was quick occupation through homesteading. Between April 22, 1889 and July 9, 1901, seven 9

10

Historical, almost romantic, narratives about homesteading suggest it was the result of Jefferson’s ideal nation of small yeoman farmers, and the grassroots “Free Soil Party.” Jurisdictions, however, that had no practical benefits from homesteading in terms of sovereignty, quickly abandoned or never adopted it. Wickett 2000, pp. 3–4.

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large blocks of lands comprising about half of the state were opened up for homesteading. The Oklahoma land rushes were relatively late in terms of frontier settlement. Most of the surrounding states, like Kansas, had generally been settled, and the farm land in Oklahoma was valuable enough to sell. Furthermore, railroads already criss-crossed the West. Given the value of the land, many people were willing to race immediately. Although the great Oklahoma land rushes may not have been as great as reported in the media of the time, there was a substantial rush and the event is entrenched in popular culture as the exemplar of homesteading behavior.11 What was absent from Oklahoma were railroad land grants. Railroad land grants were used to increase the value of lands to the point homesteaders would rush immediately. Given that the Oklahoma lands had been removed from settlement so long, the value of the land in 1890 was sufficient to induce immediate racing and no further inducement was necessary. Late Homesteading There is one final element of homesteading that seems inconsistent with it being used as a method to establish economic property: it lasted until 1934, long after there was any threat to the plenary powers of the federal government over the frontier. Indeed, not only did homesteading last “too long,” but the bulk of homesteading actually took place from about 1895 onwards. 11.2 shows the frequency of arrivals via homesteading into the sixteen most western states between 1862 and 1960, and shows there were actually three major periods of homesteading. Between 1860 and 1880, homesteading got underway in states just west of the Mississippi, and this was followed by significant amounts of homesteading until the early 1890s. Then, between 1895 and 1930 massive amounts of homesteading took place that amounted to 69% of all homesteads from 1862 to 1960. Late homesteading took place during the Progressive era when the “open” frontier was being “closed down” to open-ended public land transfers. During this time the western lands were inventoried for timber, mineral, and other resources; national parks, forests, and grasslands were established; millions of acres were removed from public access; and the general philosophy of the state was exercising its own control over the west. Late homesteading also took place well after the Indian Wars and all threats, both external and internal, no longer existed. Why would the state engage in the dissipating practice of homesteading in an era when land sales were entirely feasible? The answer follows from a change in Native American land policy that took place in the 1880s. When the federal government first negotiated treaties prior to 1870, the tribes were relatively strong compared to the federal 11

Allen and Leonard 2020.

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0

Number Homesteads 50000 100000

150000

Annual Homestead Arrivals

1860

FIGURE

1880

1900 1920 Arrival Year

1940

1960

11.2 Homestead arrivals by year

government. Despite the massive amounts of lands that were transferred away from the tribes, their holdings remained considerable. By the 1880s, the tables had turned, and efforts were started to renegotiate the treaties. When this failed, a series of legally questionable land dispossessions of Native American tribal lands took place. This culminated in the various Dawes Acts in which reservation lands were taken, allotted back to the tribal members in 160 acre lots, and the excess lands reverted back to the state. There is little question that the federal government anticipated legal challenges to the land taking: cases were immediate and continued throughout the twentieth and twenty-first centuries. In one of the most recent cases, Sharp v. Murhpy (2020, p. 591), the Supreme Court ruled that the Creek Nation in Oklahoma had not lost title to the lands given in 1866, despite the fact that the lands in question were heavily populated by non-Indians. These lands consist of three million acres in Eastern Oklahoma and include much of Tulsa. In the decision, concern was expressed over how lands occupied by 1.8 million non Creeks could be given back, but the original treaty rights were upheld. Once again, we see the benefits (to the federal government) of early and swift occupation caused by homesteading. When the federal government anticipated legal challenges and losses over the Native land dispossessions, flooding the lands with settlers led to economic rights over the land and the possibility of destroying the legal claims of Native American tribes. Occupied Indian lands necessarily meant destroyed Indian environment, physical development and infrastructure, and the presence of vested interests in maintaining settlement. The irreversible effects of settlement meant that even a legal loss could only result in a payment to tribes, not the return of the land.12 12

Allen and Leonard (2022), show that this late homesteading was very targeted, and mostly took place on lands that were questionably taken away from the tribes.

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CONCLUSION

This chapter has focused on the example of homesteading and railroad land grants as an example of systematic efforts to place valuable resources in the public domain, not because it was too costly to keep people from encroaching on these resources but because the state wanted to direct the encroachment in a particular way to reinforce its economic and legal claims to those resources. In the world of positive transaction costs, the means by which property rights are established and maintained can be counter intuitive. What on the surface looks like a tremendous dissipation in wealth in human history, was a clever (and dark) method of achieving federal control over the frontier in an era when it lacked other means to feasibly do so. Placing something of value in the public domain induces capture through possession or occupation. Possession and occupation involve real people in physical space and time, and therefore have real consequences. When possession or occupation, per se, have value, then there is some chance that an asset may be placed in the public domain. This explains why profit maximizing firms might give products away and induce a large line of customers and why Canada rushed settlers out to the cold harsh prairies to stop the United States from expanding northwards. The general lesson is that the simplistic mantra “stronger property rights are always better,” is not true. In a world of complex goods, where property rights have multiple dimensions, and where transaction costs are positive, it might be better to weaken the property rights of one asset by placing it in the public domain and thereby increase the property rights of another to the effect of an overall increase in wealth.

P A R T IV

NON-PRICE ALLOCATION AND OTHER ISSUES

When transaction costs are low, it is often the case that price is the efficient allocation mechanism. As noted by Hayek, a market price provides a sufficient level of information for people to make decisions about production and consumption without knowing anything of the real world details that lie behind the price movement. A price mechanism is costly, however, and earlier sections of this book have examined the reasons why transaction costs arise and exist. When transaction costs are positive, prices might still be used for allocation, but ownership can become divided and the scope of property rights limited. There are cases, however, where prices are too costly, and this section of the book analyzes situations where market prices are not used and other mechanisms substitute for resource allocation. Such an analysis does not seem possible without the concept of imperfect property rights. This last section includes analyses of slavery, voting, blood donations, government provision, innovations, and wildlife. Some of these methods of allocation are morally repugnant (e.g., slavery), but we examine them in order to demonstrate the wide ranging applications to which the property rights model can be used.

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INTRODUCTION

In earlier chapters, we noted that input owners who cooperate in production cede property rights to some subset of attributes of their input to the other party. Within this divided ownership, often some attributes are placed in the public domain and are exploited by the other party to the contract. Under such conditions, a wage employment contract, where one input owner is paid dollars for units of time, might be used to reduce the incentive to exploit the free attributes of some other input during the process of production. In our modern world where various technical innovations have allowed high levels of measurement and often a separation of the role nature plays in production, the marginal product of a wage worker might be relatively inexpensive to measure, and wages might work well in terms of allowing production to take place with low transaction costs. Such workers likely have a strong independence between their private lives and their occupation, and the employer likely has little ability to restrict workers outside the strict area of employment. This was not always the case. Prior to the mid-nineteenth century, the ability to measure simple things like time and distance were costly and subject to a great deal of variance. As a result, it was often difficult to monitor worker effort and theft on the job. Consequently, restrictions were often placed on workers that are no longer common. Here, we examine a few such episodes. NON - FREE LABOR

As noted in Chapter 8, before mid-nineteenth century, most production was artisan in nature and highly variable in quality. There was nothing like modern standardized goods, and different workers were generally unable to produce identical goods. Artisan production meant that individual workers within firms 219

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had to be supervised closely and that the division of labor was quite limited, especially across stages of production. The increased vertical integration and the low level of output meant that production often took place within “cottages” and families, and not factories. Because artisan goods were difficult to measure, their exchange was enforced informally through personal reputations, and disputes regarding agreements between workers and firm owners were resolved by the parties themselves. Even today, a commissioned painting might displease a buyer, but a court is unable to adjudicate a dispute over whether the painting met some subjective value of the buyer. The buyer’s only recourse is to tarnish the painter’s reputation.1 Artisan production led to different methods of theft and protection of goods within the production process. Since these types of goods were often identified with their owner and were certainly likely to be identified by their owner, the owner possessed a comparative advantage in identification. Whether these goods were intermediate or finished products, the legal owner of artisan goods was often the “protector” of the goods, and the “investigator” of any theft. Artisan owners are familiar with their goods; they know more than anyone else about their legal status, are best able to determine when and what has been stolen, and are best able to recognize their goods when possessed by others. This comparative advantage was enhanced by the local nature of markets. One consequence of all this was that prior to the nineteenth century, labor was mostly governed by the odd doctrine of “master–servant” relations. Under this doctrine, a worker was not “free” from their employer, but was rather tied to them in a relationship similar to dependent children. This meant that workers often lived with or within the control of their employers and were to be obedient to their master at all times. The master also had obligations to the servant and was required to protect, educate, and train the servant in the skills of the trade. The master essentially had an ownership interest in the servant beyond the strict productive relationship, and the servant was expected to act in the best interests of the master. In the Communist Manifesto, written in 1848, Marx and Engels expressed their displeasure at what they saw happening to master servant relations: The bourgeoisie, wherever it has got the upper hand, has put an end to all feudal, patriarchal, idyllic relations. It has pitilessly torn asunder the motley feudal ties that bound man to his ‘natural superiors’, and has left remaining no other nexus between man and man than naked self-interest, than callous ‘cash payment’. ... It has resolved personal worth into exchange value, and in place of the numberless indefeasible chartered freedoms, has set up that single, unconscionable freedom – Free Trade. (Marx and Engels 1976, p. 82.) 1

In 1954, the artist Graham Sutherland was commissioned to paint Prime Minister Winston Churchill. Churchill despised the painting, refused to have it publicly displayed, and eventually destroyed it. But Sutherland kept his commission.

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Though they did not understand the revolution of measurement that had been taking place all around them, they certainly recognized the effect it had on the creation of “free labor” which we take for granted today. Free labor was the result of increased abilities to cheaply and accurately measure time and other factors related to worker productivity. The reduction in the use of natural power sources increased the ability to identify the marginal product of workers, which increased the attraction of wages paid strictly for time on the job. Factory Colonies The transition to free labor throughout the nineteenth century had an interesting intermediate step.2 In the mid-eighteenth century, a few cases of production began to move away from vertically integrated cottage production units into something that looked like factory production. The ability to bring stages of production under one roof was partly the result of increased standards and measurements of inputs. However, this very increase in standards led to a rising problem: embezzlement. Workers, who had historically been allowed to glean scraps of material for private use and resale, were able to steal large amounts of standardized inputs which were easy to resell because their lack of artisan character made them hard to identify with any employer. The lack of a public police force at the time meant that employers were forced to deal with the problem on their own, but lacked any authority off their property. Eventually, police would be created and criminal law would be revised to deal with larceny, but in the meantime the solution arrived at was the creation of “factory colonies.” Workers who agreed to work in these colonies moved their families to an isolated part of the countryside where they worked and lived in a type of voluntary prison. This allowed for the benefits of the factory system, while restricting the ability of the worker to embezzle.3 Thus, although the prototypical Industrial Revolution factory is often thought of as the crowded urban warehouse, the factory first appeared in the rural and isolated areas of England. But these colonies contained more than just the factory, the owners-built shops, houses, churches, schools, and other amenities for the workers. They were: ... a deliberate creation, without assistance from the State or local authority and with no public services. The factory, the weirs and dams, the machine-shop, the roads and bridges, the inn, the truck-shop, the church and chapel, the managers mansion - all were devised by and grew up under the owners eye. (Fitton and Wadsworth, 1968, p. 98)

Within the factory colony behavior was restricted and monitored all of the time until the term of the contract was over. Workers would sign on for as long as seven years, and failure to fulfill the contract or failure to adhere to the 2 3

This section is based on Allen and Barzel (2011). Williamson (1980) noted that the factory was a major factor in eliminating worker theft problems.

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rules could mean fines. Workers accepted these conditions because their net wages were higher as a result of the reduced theft. It was a costly system, and once public police were instituted the colonies faded away and factories moved into the cities. Along with this, workers became free labor, and restrictions on behavior outside of employment hours ceased. Coverture Master–servant relations mostly disappeared in the middle of the nineteenth century, but within the context of marriage, another form of non-free labor existed well into the middle of the twentieth century.4 The doctrine of coverture held that a wife took on the legal identity of her husband upon marriage. This meant that wives in England and the Americas had severe restrictions on their legal freedoms. They could not own property, enter contracts, or take others to civil court. Husbands could restrict their labor force activities, owned the wives’ income, and if divorced, had custody of children and the marital property. Coverture existed at a time when infant mortality was high, fertility was difficult to control, and paternity even harder to identify. Under such conditions married women were often fully engaged in the production of children and had reduced opportunities outside the home. As noted in Chapter 8, marriage is an institution created to mitigate the transaction costs of procreation, and one cost arises over cuckolding – where a husband unwittingly raises children who are not his genetic offspring. Allen (1992) showed that sharing between couples in marriage generates an equilibrium where men and women of equal productivity marry each other and share equally. In such a situation, a low quality wife cannot marry a high quality male, but she can increase the genetic quality of her children through a secret adulterous affair that results in a pregnancy. If her husband is unaware of the deceit, he ends up supporting children that are not his own. Coverture was a response to this problem. By restricting the rights of wives, husbands were able to limit their movement and exposure to other males. In an age when wives were most productive in producing children, the costs of coverture were low. Several factors brought the end of coverture. First, the Industrial Revolution introduced many market-based labor opportunities for which women had a comparative advantage, and this raised the cost of coverture. Second, birth control methods improved, culminating in the birth control pill, which allowed wives to take advantage of opportunities outside the home. Finally, paternity became easier to establish. Geddes and Lueck show how the rights of women increased as the costs of coverture increased.

4

This section is partly based on Geddes and Lueck (2002).

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SLAVERY

Master–servant relations, factory colonies, and coverture were all examples of voluntary restrictions on worker freedoms.5 In each case, individuals agreed to restrictions on their property rights in order to reduce transaction costs and increase their net reward. Similarly, voluntary slavery, in the form of indentured servitude arises for similar reasons. Forced slavery, on other hand, is an involuntary restriction on freedoms – a type of institutionalized theft. Slavery existed in almost every ancient civilization, and was practiced in China, Europe, Africa, and among many North American tribes. It was also practiced within the context of many different religions, including all of the major ones. As a legal institution, slavery mostly ended in the nineteenth century, but even today, it exists in many parts of the world through black market human trafficking. To understand the institution of slavery, it is necessary to compare slaves and free laborers in production. This allows an understanding of what forces permit slavery to flourish and can help in attempts to reduce or eliminate it. Like all other forms of organization, the details of slavery hinge on the transaction costs involved. Such an analysis does not condone the practice, of course. The Slave “Contract” Labor services, routinely exchanged in the market, are subject to contract. The typical contract for the services of a free worker transfers a rather narrow, usually short-term set of attributes from the labor owner to its buyer. Some types of slavery, too, may be viewed as an unusual type of labor contract – one, however, that gave slave owners extensive rights over their slaves. As noted, there were two types of slavery: forced and voluntary. Forced slavery was initiated by theft – free people were captured and, as the term suggests, were forced into slavery.6 In the case of forced slavery, the arrangement most often extended over the slave’s lifetime and descendants. Voluntary slavery was the result of an explicit agreement, presumably in the belief that entering the contract would be beneficial to each. Voluntary slavery typically specified a shorter duration and gave the owner fewer rights over the slave than did the forced slave contract.7 In some cases, voluntary slavery resulted when people who had posted themselves as loan collateral defaulted on their contract and lenders assumed ownership over them. Indentured servitude, a form of voluntary slavery, was a direct method of repaying loans. Such loans often served to finance the passage of indentured servants from Europe to America. To repay the loan, indentured servants worked in America for a number of years virtually as slaves. The duration of the servitude was 5 6 7

Based on Barzel (1977). See Bean and Thomas 1974. Master–servant relations were a type of volunteer slavery.

Part IV Non-price Allocation and Other Issues

224 $/Day

A M'

B

U M" 0

FIGURE

M 24 Hours of Leisure/Day

12.1 Slave Labor Supply

determined in an auction in which the winning bidder was the person who bid the shortest number of years of service and bought the loan contract from its previous holder – often the captain of the passage ship. The servant worked out their debt to the final lender, usually an American farmer. The term “contract” implies a voluntary relationship, indeed, a relationship from which both parties expect to gain. The term fits voluntary slavery well, but does not apply in the case of forced slavery. Free persons, having been forced into slavery, did not expect to gain from their change in status. Once someone has been forced into slavery, however, they may end up entering subsequent exchange relationships with their owner. Slave Labor Supply Slaves became the poorest of people. A recognition of their poverty is essential if various slave practices are to be properly understood. The utilization of slave labor per unit of time may be explored through the conventional laborleisure choice analysis. Figure 12.1 illustrates such an analysis, except that in addition it recognizes the effect of fatigue. Moving along a given budget line to the northwest means that leisure hours are falling with increased income. At low levels of labor supply, income increases with reduced leisure, but beyond a certain point in the working day, fatigue becomes dominant and worker productivity falls. At some point output is maximized before all the 24 hours in the day are used, and then more hours of work lead to lower output. A free worker with budget M maximizes utility by choosing the leisureincome combination at point A. A person subject to a budget constraint M obtains his entire income from the use of his own time since consumption of 24 hours of leisure provides no income. A budget constraint M implies

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that the individual has other, non-wage daily income equal to the vertical distance between M and M – even with 24 hours of leisure the individual has income. Such a free person would also maximize utility along the negative sloped portion of the budget constraint. The budget line M belongs to a free person with a negative non-labor income; that is, a debt-payment obligation. At 24 hours of leisure, this person owes income. When leisure is a normal good – a highly plausible relationship for a net debtor with low earning power – there is an increasing supply of labor as the budget constraint shifts inward – the poorer person works more hours per day. Given such income elasticity, as the fraction of a person’s potential labor income that is devoted to debt repayment increases, the person’s labor supply accordingly increases.8 Workers incur maintenance expenditures – the minimal expenditures on items (e.g., food, medical care, shelter) that will sustain them at a given exertion level. Such expenditures most likely increase with the amount of labor supplied. Maximum net income from work is the largest present value of labor income a worker is able to produce net of the present value of their maintenance expenditures. That particular labor effort associated with producing the maximum net present value also permits the largest possible debt payments. If we interpret the budget lines as being drawn net of maintenance expenditures, then point B on budget line M would show the level of exertion that defines the largest debt that person can pay while earning just enough to sustain themselves. A free person with a commensurate debt will presumably choose to operate at such a level of exertion. Policing costs aside, a forced slave can be viewed as a person who operates precisely at that point. The owner of a forced slave will require the effort that, net of maintenance expenses, will yield the highest present-value income stream. Any disutility from work will be ignored by the slave owner. Thus, the extra food given to a slave was not an act of benevolence but a reflection of the extra exertion. A forced slave may be compared to a free person who has contracted to operate in exactly the same way the slave is required to. A forced slave, then, is someone who is deprived of their entire net present value. This amount would be what would be necessary as a payment for manumission, which was the practice of a slave buying their freedom. In the era when slavery was legal, the question of manumission was pertinent. The practice of slave self-purchase poses a major puzzle: How could a slave, another person’s legal property, purchase their own freedom? In order to resolve this puzzle, transaction costs, particularly policing costs, must be considered. 8

The supply of labor also depends on the intensity of work, which is usually viewed as given but is actually a choice variable. We abstract from it here; for a more elaborate analysis, see Barzel 1977.

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Part IV Non-price Allocation and Other Issues

The Costs of Supervision Since slaves were the full-fledged legal property of their owners, all the income they could generate was legally their owners’ as well. Owners who took anything from their slaves were simply taking something that was legally theirs to start with. Owners had the legal right to take; they also had the power. How, then, could slaves accumulate wealth, sometimes to an extent that enabled them to purchase their own freedom? Had the capabilities and net output of slaves been freely measurable, wealthmaximizing slave owners would indeed have extracted every last ounce of product from their slaves. Under these conditions, which would have permitted perfect and complete ownership, it is ironic that slave status itself would have been inconsequential. Had policing been costless, the owner could have obtained the same income while allowing the slave to operate as a free person; for instance, he could have done this by receiving an explicit payment of the same value as that generated by the slave’s services without requiring slave status. The free person, however, would still have had to work exactly as a slave in order to make his payment, or as a debtor to pay off his or her debt.9 This is the Coase Theorem, which states that when rights are perfect – as they are assumed here – resource allocation is independent of the ownership pattern. In reality, the evaluation of inputs and outputs is costly, and policing is required to induce effort. As we shall see, accumulation by slaves is thus possible. When the net output of a free worker can be determined at low cost, it is advantageous for him to operate independently, since this eliminates the problem of poor incentives to work. Such was not the case with slaves; the labor services slaves could provide belonged to their owners. Even when output was easily measured, slaves would have gained from producing less and thus had to be induced to produce more. The distinction between slaves’ and free workers’ incentives became even more acute for tasks that free workers performed by the hour. Free workers wanted to convince their future employers that they were more productive than they actually were; since it was difficult to ascertain their true productivity, their wages would consequently be higher. Slaves, on the other hand, wanted to convince their owners that they were unproductive to reduce expectations of performance.10 Slave owners, then, had to spend resources to figure out how productive the slaves were and how hard they could be driven, as well as to actually supervise their efforts or output. Assuming diminishing marginal productivity in supervision effort, slave owners would have stopped short of extracting the maximum output of which

9

10

Had all rights been perfect, which requires zero transaction costs, not only would slave status have been rendered devoid of significance, but forced slavery would never have arisen in the first place, since one person would never have captured the rights of others. Slaves had to be careful not to do too good a job of deceiving their owners, since owners who thought their slaves were not worth their cost would have found them expendable.

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slaves were capable.11 The difference between a slave’s maximum and actual output became the slave’s economic property. As a rule, this property was not in the form of the output they produced for the slave owner, but, rather, in the form of reduced effort. Still, slaves were able to convert some of this potential into material goods. Slave owners had to choose between supervising slave output, which is comparable to what employers have to do when free workers are employed by the piece and supervising their effort, which is comparable to what employers must do when they employ free workers by the hour. Monitoring effort required continuous supervision, for whenever slaves were not watched, they had little incentive to perform. Monitoring output required overseeing the quantity and quality of what was produced and, indirectly, its effect on other productive inputs such as equipment. Slave owners used quotas to both help supervise slaves and incentivize them to work. Quotas were estimates of productivity and were subject to error. A quota that was too high would have resulted in the over utilization and destruction of slaves. Owners selected the quota that would maximize their own wealth and were expected to enforce the production of that quota but no more. This meant that owners left their slaves with the difference between the quota and the maximum they could produce – a difference slaves could exploit to their advantage. Given the two methods of extracting output, and that slaves varied in their abilities, owners could offer supervised slaves the option to work under the quota method, setting the quota to exceed the supervised output. With this as an option, highly productive slaves chose to operate under the quota, since for them the quota obviously was not excessive. These slaves essentially received a residual earning. Though they allowed slaves to retain output in excess of the quota, slave owners were aware that the level of the quota could have been increased to begin with. They also were aware that they could confiscate any wealth accumulated by slaves. However, such a confiscation would have been equivalent to breaking the contract and would have defeated the purpose for which the quota was established to begin with. Thus, in pursuit of their self-interest, and not out of any benevolence, slave owners permitted slaves to own and to accumulate things. Slaves seldom became wealthy. Nevertheless, the free time they were able to gain enabled them, among other things, to grow vegetables, fish, and hunt. Their owners and neighbors were ready buyers for what slaves had to sell. Slaves who were ultimately able to buy their contracts were, as a rule, household slaves, sometimes well-trained ones. Because their tasks were diverse, they

11

This statement applies to the average slave. Slaves who were mistakenly asked to do more than they were capable of doing were in serious trouble, compared with other slaves, and sometimes died of exhaustion.

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were difficult to supervise, a difficulty that increased with the skill of the performer. Household slaves, especially skilled ones, had better opportunities to accumulate than did slaves who worked in the fields.12 The need for supervision and the desire to economize on its cost made slave ownership less than perfect. Slaves were able to capture some of these unenforced rights – in this case rights to themselves. Success, partly due to skills in feigning inability, on the one hand, and to activities such as fishing, on the other, as well as the luck of having errors made in their favor, eventually enabled some slaves to buy their own freedom. Slave Consumption The sharp disparity of interests between slaves and slave owners was not confined to slave effort and its supervision; it also extended to consumption practices. Slave owners could not drive their slaves hard unless they made sure that they were properly maintained – that the nutrition, medical care, and other services slaves received were commensurate with the effort required of them. Correspondingly, as Fogel and Engerman (1972) have shown, in the United States, slaves received what by nineteenth-century standards appear to have been good medical care and a nutritious diet.13 Slave owners, however, had little incentive to let their slaves consume food outside the least-cost diet, or to let them consume other services beyond the lowest-cost ones required for maintenance. Slaves, on the other hand, were not necessarily harmed when their productivity was lowered. Obviously, they preferred more palatable food, which they would have substituted, in part, for less appealing but more nutritious food. One important tool slave owners possessed for minimizing maintenance costs was the ability to control consumption directly. They accomplished this control by simply supplying consumption items in kind rather than providing slaves with a budget and allow slaves choice in consumption. Thus, in the American South, slave diet contained much corn and sweet potatoes, then considered nutritious but less desirable than the more expensive wheat and white potatoes even poor free farmers chose to consume. Slave owner control of slave consumption, however, was not absolute. Slaves would, on occasion, avoid taking medicine, since in their eyes remaining ill was sometimes preferable to returning to work. Slaves also traded food 12

13

In the Pulitzer Prize-winning historical novel, The Known World, by Edward Jones, the slave Augustus Townsend is a talented wood carver and boot maker and is given incentive contracts by his owner William Robbins. Eventually, Townsend is able to use his acquired wealth to purchase his freedom from Robbins. Fogel and Engerman, however, interpret their findings on nutrition to mean that slavery had benefits for slaves. Applying the property rights approach, we see that any extra nutrition for the slave was a matter of wealth maximization on the part of the owner and was necessary to extract extra effort from the slave.

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rations for alcohol on occasion. That providing consumption in kind was intended, at least in part, to restrict choice is demonstrated by the fact that owners not only refrained from supplying alcohol but, most tellingly, also took various costly steps to deny slaves access to it. Drinking reduced slave productivity, and owners made a concerted effort to make drinking expensive to slaves.14 Enforcing Property Rights with Slavery The legal ban on both forced and voluntary slavery is now universal; however, in earlier eras, various restrictions were placed on both practices. Voluntary slavery was a contractual arrangement that both parties entered into because they expected to gain from it, while under forced slavery it was only slave owners who gained. Eventually all states abolished slavery, most of them voluntarily. Needless to say, slaves had little direct influence on the abolition decision. Issues of theft may have been partly responsible for the abolition decision. Because of theft, the institution of slavery, both voluntary and forced, may entail costs that impinge on free persons, who might consider them excessive. Two forms of theft are associated with the institution of slavery. Already mentioned is the fact that theft was the initial step in forced slavery. The other form of theft occurred when slaves escaped. From the slave owner perspective, an escape meant the loss of a valuable productive asset. The loss that owners incurred due to escape must be compared to the policing costs associated with theft. The enslavement of free people has largely been a consequence of raids and of full-fledged wars among nations. For centuries, West Africa was subject to raids and was the main source of slaves for the American South, the Caribbean, and South America. Since losers of wars and raids were not the winners’ countrymen, one would not expect states to outlaw that source of slavery. However, raids in which free persons are captured and turned into slaves against their will can also occur within a country. Free persons will take steps privately to protect themselves against enslavement; however, because enslavement is a theft, the institution of the state is expected to be used to enhance the economic property rights of the individual over themselves. The most obvious use of the state machinery is to make enslavement of citizens a crime. A more extreme step is to prohibit slavery altogether.15 Enslaved persons would have found it exceedingly difficult to demonstrate that they were forced into slavery in a society that permitted slavery. The 14

15

Many slave owners also practiced forced baptism and paid for preachers to perform religious services. Although this took away from work time, it also allowed for the invocation of God to “not steal from the owner or run away.” Consistent with this view is the observation that raids to acquire slaves declined after the colonization of Africa. Enhancement of property rights within colonies increased the value of the colony to the colonizers.

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returns from such theft, then, are higher where slavery is permitted than they are where slavery is prohibited. Conversely, the threat to free persons of being turned into slaves is relatively low in countries that prohibit slavery.16 The fear free people have of being turned into slaves may partially explain the ban on slavery.17 A different kind of cost arises in the case of escaping slaves. It is generally true that certain costs of protecting property from theft are assumed by the state. Elsewhere we suggest as a general proposition that activities will be banned if police protection is very costly. If, as compared with the private value of slavery to slave owners, the cost to the police of recovering escaped slaves was excessive, slavery would be banned. The higher the danger to a country’s residents of being forced into slavery and the higher the cost of recovering escaped slaves, the more likely it is that slavery will be prohibited. For a long time in the American South, being a slave and being black were almost synonymous. This drastically lowered the costs of slavery in the region.18 In the South, free people, nearly all of them white, did not have to fear becoming enslaved, and escaped slaves could readily be identified and captured. As the population of free blacks grew, however, the distinction between a free person and a slave became more difficult to establish.19 Consequently, the costs of slavery increased, and the net gain from the institution declined.20 If slavery were legalized in our own society, the distinction between free people and slaves would be more difficult to establish, and the problems of the forced enslavement of free people and of capturing escaped slaves would become even more acute than they were in the Old South. It is not surprising, then, that in many societies slavery was severely restricted and that it is now universally prohibited. The demise of indentured servitude may have been due to forces similar to those that led to the demise of slavery; indeed, the problem of escape was likely greater. At its inception, the population in America was sparse, and servants, 16

17

18

19 20

Nevertheless illegal slavery still exists. According to a 2018 UN report, 40 million people around the world are enslaved. Most of these people are women and children. Most slavery takes place in the developing world where state institutions against slavery are relatively weak. According to Jewish law, Jews were allowed to keep other Jews as slaves. The law required, however, that all Jewish slaves be freed by the onset of every Sabbatical year. If during a Sabbatical year one spotted a Jewish slave, it was clearly illegal. This constraint on slavery reduced the gain from illegally enslaving other Jewish individuals, and it is consistent with the hypothesis presented here. The identification of slaves with a particular people is the apparent source of the term “slave.” To the Slavs the term “Slav” apparently meant “person.” Most of the Slavs present in ancient Rome were slaves, and the Romans used the term meant for one to identify the other. Southern states imposed various restrictions on manumission, perhaps in order to prevent the formation of enclaves of free blacks. These efforts were not entirely successful. Some slaves who were, in fact, freed by their owners chose to retain the legal status of slave, presumably to retain the owner’s protection and to reduce the chance of being forced back into slavery with another slave owner.

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at least from Germany and Ireland, were easily distinguished from free people. Over time, the population grew and diversified, making escape easier and perhaps also making the enslavement of free people easier, thus lowering the net benefit of the institution to the originally free population. By the end of the nineteenth century, indentured servitude had largely been abolished, perhaps because the costs of policing the institution exceeded its rewards.21 The current prohibition of slavery implies that each individual is the owner of the capital asset embedded in himself or herself. The abolition of slavery was accompanied by the transfer of such capital assets from the previous slave owners to the slaves themselves. The prohibition of slavery also entails additional restrictions on contracting. Essentially, when workers contract for the supply of their own labor services, only short-term contracts are legally enforceable. These additional restrictions may also reflect the attempt to make the theft of people more costly. CONCLUSION

Throughout history there have been a number of means by which various forms of labor have combined with other inputs to engage in production. These forms often greatly restricted the rights of labor but also restricted the rights of those who directed it as well. These arrangements were designed to mitigate the transaction costs that arose in the particular contexts, and in times when the ability to measure even the most basic things was often impractical, the labor contracts took forms that today would be considered oppressive. Forced slavery was an oppressive institution and required an initial theft to exist. Our analysis of slavery helps understand its odd features. Even though forced slaves were stripped of rights, in practice ownership over them was neither complete nor perfect. Slave owners had to spend resources supervising the work effort and consumption pattern of their slaves. They also had to prevent their escape. Such efforts were subject to increasing costs, and attempts to economize on these costs included granting slaves various rights. In some cases, slave output rather than their effort was supervised. The attempt to lower the cost of supervision then included granting slaves the right to part of the output or of their own time. These slaves, though legally their masters’ property, were able to accumulate wealth and occasionally to buy their own freedom.

21

The institution resurfaced under a new guise in the nineteenth century, with the importation of Chinese workers, a newly distinct set of people, for railroad construction. Like its predecessor, it did not last long.

13 Property Rights in Non-market Allocations

INTRODUCTION

The property rights approach to the study of economics was first used in market settings and has been very successful in the study of market behavior and business organization. Indeed, property rights tools may be used even more successfully to analyze situations where resource allocation is partly or fully taking place in non-market settings. Under the neoclassical approach, where rights are perfectly defined, nothing is lost by quickly dispensing with the topic of property rights, for there is little to say about them within that model where prices determine everything. Indeed, the neoclassical model may provide satisfactory answers to many problems in situations where prices play a key role in allocation. For reasons unknown, those economists who have contributed most to the study of property rights have tended to be strong advocates of markets with unregulated prices. The contention is that people and the economy thrive when left to their own devices, and that government intervention tends to reduce wealth. In the market, the argument goes, prices move resources to their highest-value uses; when prices are not given the opportunity to perform their function, misallocation results. Government intervention is deemed acceptable in such areas as national defense, police, the courts, and the money supply; such intervention is said to be desirable only inasmuch as it facilitates the functioning of markets or corrects a “market failure.” Despite the prevalence of this line of reasoning, this might be called the “fallacy of the free market.” Markets do not work for free, and though neither does the state, government regulations cannot be dismissed on a priori grounds. It is quite possible that under some conditions government regulations may complement or enhance the actions of individuals in markets by improving their property rights on some dimension. 232

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Non-market situations are where market prices are eschewed or suppressed, and in such cases, the neoclassical model is incapable of explaining how resources are allocated. Here, the property rights approach attains the utmost importance in the analysis of decisions about allocation. The irony is great, for champions of the free market have developed tools that are most powerful when they are used to analyze non-market – including socialist – economies.1 Although the property-rights approach applies to all human behavior, organizations, and institutions, any serious attempt to demonstrate this would prove too lengthy and too speculative. In support of the assertion, however, we first offer a brief discussion of the applicability of the property rights approach to two specific areas of non-market allocation: (1) allocation by voting in market settings, where it is shown that individuals sometimes choose to bypass the market and instead adopt non-market allocation devices, and (2) allocation by voluntary charitable behavior, where it clearly demonstrates an advantage over market behavior. We then briefly examine the function of private property rights and the method of inducing people to perform in a non-market economy. ALLOCATION BY VOTING

On occasion, individuals allocate resources by voting – a mechanism that explicitly bypasses the use of prices in favor of non-price allocation. Individuals who use markets retain control of how they use their wealth, maintaining full discretion over what to purchase. Within voting organizations, on the other hand, individuals are subject to constraints imposed on them by their fellow voters. Yet by their own behavior, individuals demonstrate that they value some of these constraints even though they reduce their freedom of action. Voting is used in the public sector, but also in nonprofit settings like universities and churches, as well as many profit-seeking settings, including shareholder corporations (mostly to elect officers) and in condominiums (to make an array of operating decisions). The origins of organizations such as corporations and condominiums, in which voting is used, lie in the operations of entrepreneurs. In the case of condominiums, for example, developers typically erect the housing units and related structures and complete other preparatory work before selling the units to individual buyers. Developers do not have to sell housing units as condominiums. Another option, one that maintains the owner–occupier tax advantage, is to sell the units to individual buyers, who operate independently of one another. As always, developers will choose the property right system that promises the largest difference between the aggregate selling price of their units and the costs they incur. In fact, condominium developers are offering buyers packages that consist of both the physical structures and the rules that will govern some aspects 1

As Wing Suen pointed out, the irony is compounded by the championing of the use of prices in socialist systems by such eminent economists as Lerner and Lange.

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of the prospective owners’ future behavior – rules that include decisions by voting.2 These developers offer the units as condominiums rather than independent ones because they expect their buyers to pay a higher price for condominiums than they would if they were to purchase the units independently. Clearly, condominium buyers value the distribution of property rights that constrain them to allocate resources by voting (e.g., on whether or not to build a swimming pool, or replace the roof) more than they value distributions that, by contrast, allow decisions regarding the supply of such services to be made in the market.3 Voting often arises in organizations where the owners of productive resources are also the consumers of its output. The resource owners can coordinate through exchange with each other and sell their output back to themselves through output prices. Any market exchange, however, is costly and we have considered the transaction costs related to these exchanges, including the problem of unpriced attributes left in the public domain. The consumers might alternatively form an organization around production and own shares in the enterprise. These shareholders require a mechanism for the collective use of their resources, and voting is a method of doing so. Voting allows for joint ownership and decision making. Voting, of course, is also costly. Voting is costly for two reasons. First, voting processes can be manipulated to transfer wealth among voting members. One form this can take is strategic hold out, in an effort to induce a side payment to have a vote be swayed one way or another. Transfers of wealth are not, by themselves costly, but they encourage efforts to establish such transfers and efforts to prevent them from happening, and the cost of these efforts are transaction costs. Second, voters must collect information on matters put to vote and may try to free ride on the information collected by others. When voting mechanisms can be designed to mitigate these costs such that the net wealth created is greater than that of a market allocation, voting will tend to arise.4

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In an analogous sense, the condominium developer is designing an “institution” or “political units” under which the homeowners will live. In this case incorporation is an option for residents. Presumably, developers take this into account. Here a political unit may emerge as a consequence of the quest for profit. Buyers implicitly choose the associated political restrictions. “Black box” approaches to property rights tend to assume that fewer restrictions always make participants better off. This follows from the neoclassical structure of their models which usually incorporate property rights as a constraint. In such a framework, a relaxed constraint always improves welfare. Restrictions on property rights, however, are always there for a reason, and hence their elimination is not necessarily Pareto improving. See Barzel and Sass (1990) for a discussion of how voting rules vary in condominiums, corporations, and political elections based on these transaction cost problems. See also Hilt (2008) who discusses the way corporate firms in the early nineteenth century designed their voting systems to mitigate the power of large investors to exploit smaller ones.

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The existence of voting reveals that individuals sometimes prefer non-price allocation to allocation by price. The use of prices, then, is not always the most efficient method of allocation. DONATED VERSUS PURCHASED BLOOD

The use of blood for transfusions was developed in the late nineteenth century, but its widespread practice and the development of large-scale blood banks happened during World War II. Blood and blood products have become an integral part of medical treatment; however, universally whole blood is supplied through voluntary donations rather than through market prices. These donations are made despite the fact that different types of blood vary in terms of their value. For example, about ten percent of people have O-negative blood, but this type can be transfused into almost anyone. The inability to price blood in general, and specific blood types in particular, means that shortages are common.5 In a classic article Kessel (1974) argued that an unhindered market in blood donation would not only achieve allocative efficiency, but also resolve the problem of high levels of hepatitis within purchased blood. In his words, Paid blood need not per se be impaired blood. Whether in fact it is impaired depends ... not upon whether it was paid for, but from whose veins it comes. There is no reason why paid donors could not come from the same social class that the voluntary donors come from. (1974, p. 272)

Kessel argued that the market for blood at that time did not function adequately because of government regulation, and that an unregulated market would be able to sort donors and mimic volunteer donations. His argument is an application of the Coase Theorem, and therein lies the issue. Missing from Kessel’s argument are positive transaction costs in market exchanges. Alternative mechanisms, where resources are allocated by inducements other than price, can sometimes generate a higher net gain than market transactions. In the analysis of non-market organization for the supply of blood, we provide a different explanation as to why the quality of donated blood is higher than that of purchased blood. Blood, like other commodities, is a collection of attributes whose levels vary from one specimen to another. In particular, some blood specimens are infected with hepatitis and other diseases, while others are not. The lower the probability that a batch of blood is infected with disease, the more valuable it is. In general, buyers would not pay a high price for the low-quality specimen if they could costlessly (or at least cheaply) assess it, but this is not the case in the market for blood. By simply posting the two prices at which they would be willing to buy the two types of blood, buyers are unlikely to secure the 5

Costa-Font, et al. (2013).

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desired qualities. Because sellers prefer selling their products at higher prices, blood buyers need to be able to determine which grade of blood they are getting if they wish to avoid paying the higher price for the inferior commodity. In the time period Kessel investigated, however, the test for hepatitis infection in blood was virtually worthless, so it was difficult for buyers to distinguish between the two kinds of blood. As a consequence, the market for blood performed poorly, and the proportion of infected specimens purchased was high. Even with modern testing, whole blood is often too fragile to undergo all of the tests and still remain useful.6 However, knowledge of whether any blood specimen is tainted with disease is not always difficult to come by because people often know – or at least suspect – when they are carriers of disease. The problem is that impersonal markets are ill-suited for extracting the personal information and determining the quality of such a commodity as blood. Because information about blood is not costless to all concerned, the value of market exchanges of blood is greatly lowered. The information is free to a subset of individuals – the sellers – but the market is unlikely to extract the information costlessly because sellers, who can gain by concealing it, are able to do so. Using a monetary reward happens to be disadvantageous, for example, in securing hepatitis-free blood. The incidence of hepatitis among drug addicts is high because they tend to infect one another by sharing needles; these are the same individuals for whom cash for blood is a particularly attractive trade.7 The attempt to purchase blood in the open market, then, is likely to attract a relatively large proportion of carriers.8 Separation is nevertheless possible but not within the unrestricted market setting. Obtaining blood from donors instead of purchasing it for cash alters the selection criteria of suppliers because it tends to cheaply screen out people who know they are carriers. Wouldbe donors must be persuaded to donate. They respond because they wish to help other human beings. People who know or suspect that they are carriers are aware that their donation will do harm. They are simply expected not to donate. Of course, cash markets are not used by accident; they economize on some of the costs of exchange. The use of donors in lieu of cash markets incurs costs that are absent from cash markets. For instance, volunteers are not generally the lowest-cost suppliers of the commodity or service they donate. The costs and gains of using markets as compared with other allocation methods, such as charity, differ across commodities. Given the difficulty of testing for 6 7

8

Grabowski and Manning (2016). The fact that transaction costs are positive suggests that cash is not as neutral as it is often thought to be. If, for example, blood sellers were paid in non-transferable tuition vouchers, it seems highly likely that the fraction of infected addicts among sellers would be smaller than it was with cash as the means of payment. There are, of course, various methods of screening out individuals who are likely to be carriers. Although these methods are used, they still remain costly and not completely effective.

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the presence of hepatitis and the HIV virus that causes AIDS, blood is one commodity for which the advantages of non-market over market allocation are evident. Interestingly, the supply of plasma is mostly done through the use of dollar prices. Plasma is a component of whole blood, and is obtained by directly removing the plasma from the donor’s blood and returning the red blood cells to the donor. The process takes about 1–2 hours, and the donor can do the procedure up to two times per week. Donors in the U.S. receive about $35/hour, and the U.S. generates much of the world supply. The key difference between plasma and whole blood is that plasma is not directly transfused into another person. Rather, it gets broken down into various protein products and this process kills any disease or virus along the way. Since the plasma is cleaned in processing, the adverse selection problem of market prices is removed and prices are used in its supply. The cash-market seller’s ability to gain by knowingly passing off low-quality specimens as high in quality is common to many commodities besides blood. Nevertheless, charity is not expected to be used in all such cases. The precise nature of the quality problem is likely to differ from one commodity to another, and each should generate its own charitable response. Mechanisms other than charity may be more effective in securing the desired quality for some of these commodities. ALLOCATION BY GOVERNMENT

The government of every country plays an important role in economic activity, and some government roles are enormous. All governments engage in nonbusiness activities, such as conducting foreign affairs and operating the courts, and virtually all also engage, to varying degrees, in more businesslike activities, often conducting operations that in some other countries are run privately, usually for profit. It is occasionally argued that governments should seek profits when they manage their enterprises, and some government enterprises may actually seem to operate in that way. Even when profit maximization is the stated objective of the government enterprise, however, the identity of the residual claimants often remains unclear. The difficulty of identifying such individuals and the common claim that government is generally wasteful and inefficient both suggest to many that private-property rights are absent from government operations. Indeed, former communist countries claimed to have abolished private-property rights, at least with regard to the means of production. Private property rights, however, must exist to some extent in a functioning economy.9 The notion that government is inefficient also cannot be correct. After some general comments on 9

In the aftermath of the breakdown of Eastern European communism, many of the functionaries of these regimes who continued to operate in their old institutions actually landed on their feet. This implies that these individuals had substantial economic rights.

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individual maximization, we shall try to determine what can be inferred from the sheer existence of a government-run enterprise, using a city bus system as the example. We then consider the meaning of an arbitrary detail of its operations – the activities of bus drivers – and move on to more general aspects of the operation of such a system. We do not inquire directly into what the proper areas for government activity are; rather, using a property-rights approach we offer a glimpse into the way a government functions. The assumption of individual maximization is heavily exploited in economics to analyze profit-seeking enterprises and private consumption. But individuals maximize in all circumstances, and because governments are run by people, government activity ultimately results from the interactions of maximizing individuals. Contrary to the implied assertion by some economists and other scholars, one consequence of maximizing behavior is that government actions are never deliberately wasteful or capricious. If “waste” means that some individuals lose from an action from which no one else gains, such an occurrence is inconsistent with maximizing. Whoever takes any kind of action must expect to gain from it; indeed, the perceived net gain must always be the largest one available. An action that appears to others to have been wasteful must, nevertheless, have been expected to generate a gain to the person who undertook it. Moreover, such a person must not have believed they could gain more by acting differently. The resources under consideration are ultimately allocated to a particular use by whoever is in control of them – whoever has the economic property rights. The logic behind the allocation is straightforward. Such resources have alternative uses, each with its own valuation. The ability of potential users to bid for the resources, however, is subject to constraints. For example, perhaps bids may be made only by citizens, elites, or party members. Similarly, bids may be restricted in form (e.g., lecture fees or promises of future high-paying jobs, open cash bids being prohibited). Whatever the rationale for the constraints, a maximizing controller of resources will allocate such resources to the person who makes the highest bid as determined by the controller.10 The winning bid generally is not the same as the one with the highest value in the absence of the constraints. In this regard, resources may appear to be wasted, particularly in the eyes of those who are not aware of the constraints. Given the constraints, however, other potential users of the resources that appear to have been wasted must not have bid high enough for them. Applying this reasoning somewhat more generally, it can be concluded that the lower the perceived net gain from an action to the individuals who have the right over it, the lower the chance that such an action will be taken, no matter how beneficial the action is supposed to be or how large its expected gains absent the constraints.11 One must bear in mind that the higher the potential 10 11

The constraints are, of course, also imposed by individuals who are maximizing. The same considerations apply to the process of selecting government bureaucrats and government projects – and ultimately to the selection of the government itself.

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benefits of an action, the more the beneficiaries are able to bid for it; “ability,” however, may be difficult to translate into an actual bid. In order to analyze individual behavior in a government organization, it is necessary to address the relationship between private ownership and government activity. Because maximizing people will act only when they expect to gain from their actions, one must be able to determine who gains and who loses from government actions in order to connect the actions with ownership. Selecting, for example, a city bus system, one must ask who owns it, that is, who has at least some of the power to consume its services, to obtain income from it, or to alienate its assets. The “city” is not a satisfactory answer, because it does not identify the individuals who gain when the buses are running on time and lose when they are not. Answering “the city” denies that such individuals exist and therefore implies there is no residual claimant to the operation of the bus system. Yet if no one gains from improving the operations of the bus system and no one loses by letting the system deteriorate, it must lie in the public domain. Allowing the bus system to deteriorate requires less effort than maintaining it, so it would cease to function if it lay in the public domain. Similarly, it cannot be true that the bus system lies in the public domain when access to its assets is constrained. For instance, in a functioning system, attempts to commandeer buses are likely to be punished. So long as the city bus system is not totally paralyzed, property rights over it must exist.12 Various observed bus-system activities, outlined in the following paragraphs, imply the specific existence of certain private property rights. The fact that riders use city buses is an indication of the existence of a whole system of private rights. The activities of employed bus drivers illustrate the mechanics of this system. Employed drivers are fired unless they perform some minimal level of services. The drivers engage in an exchange with their supervisors, and exchanges constitute a reassignment of property rights. Here, the drivers acquire the right to a wage while relinquishing some rights over themselves by performing driving services. Drivers may be asked to do more than the specified minimum; if they are to perform beyond the minimum, they must be given an incentive. Such an incentive need not be higher pecuniary pay; it may take the form of a better chance for promotion, a more convenient work schedule, or an easier route. Whatever its form, no extra effort will be forthcoming without it. Drivers have at least some rights over themselves; they control the level of effort, and they exchange rights over particular effort levels for other rights. 12

The claim, made by leaders of communist states, that private property had been abolished and that all property belonged to the state seems to have been an attempt to divert attention from who the true owners of the property were. Evidently, these owners also owned the rights to the terminology. It is ironic, at least in terms of the rhetoric, that communist states had a hard time keeping resources such as air and rivers from getting into the public domain (the ultimate in collective ownership!). As a result, the value of these resources was reduced to a level much lower than the one they occupy in capitalist states.

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Employed drivers cannot operate in isolation. Someone in the bus system must gain from forming the contracts that induce the drivers to perform busing services. Similarly, the mere fact that drivers are given routes to drive and schedules to maintain implies that someone has been induced to perform the functions of creating the routes and schedules. It can likewise be inferred that certain individuals are induced to maintain buses; otherwise the buses would not be in operating condition. As long as bus lines are in operation, then a whole array of people must be rewarded for performing individual functions. The bus system may be managed bureaucratically and may function sluggishly. Still, some property rights must be granted to the individuals associated with it; otherwise no service whatsoever would be forthcoming. Governments often seem to set output targets at levels such that at the margin valuations differ from costs. In communist countries, such goals were often stated explicitly. The constant shortages characteristic of such regimes arose from prices that had been set lower than was required to clear the market and from allocations that simply seemed arbitrary. Government enterprises were affected by such policies in various ways. How would the operations of the bus-system repair shop have been run under such conditions? Presumably, from time to time the repair shop would have been hampered by a shortage of parts. As long as buses were running, we must conclude that individuals in the repair shop were being rewarded for getting the buses to work and that the rewards were larger when the repair-shop services were better. Repair-shop personnel would have gained by having parts on hand, and consequently should have been willing to spend resources in order to secure them. They might, for instance, have attempted to trade with the repair shop of another city’s bus system or with a truck repair shop. Alternatively, they might have offered a special reward to the parts producers for furnishing extra parts. Such producers, as is generally true under price controls, would not have been likely to produce at full potential for the controlled-price segment of the market. They might readily have been induced to expand output, however, if the reward had exceeded the control price.13 The details of such operations cannot be determined by an armchair economist, but maximizing behavior implies that the discrepancies between marginal valuation and marginal costs must generate forces toward their elimination. Indeed, as was shown in the discussion of price controls in Chapter 9, 13

Some non-market economies are called “command” economies; a command economy is one in which the planner imposes an output target along with the control price. Imposing as the term may sound, it will be obeyed only if it sets low targets. Because inputs are never uniform, and because of random fluctuations, the output target the commander will set must, as a rule, fall short of maximum output. Otherwise, as in the case of slavery, the commander will incur losses by punishing those unable to obey the command because it is excessive. If output is costly to measure, shirking with regard to the target output may also occur. The quantity supplied, then, is expected to increase if the reward is larger; an increase will not be forthcoming if it is simply commanded.

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once the added adjustment of transaction costs is accounted for, the discrepancies must be eliminated entirely. This attainment of equilibrium simply follows from maximization. The equilibrium itself, however, is likely to differ from equilibria reached under different sets of constraints. Given the governmentimposed restrictions, the adjustment costs may be so high that the final output may lag drastically behind the corresponding market outcome. The advantages of allowing residual claimants to operate in an economy are clear. In the context of new opportunities for the bus system, suppose it is discovered that the residents of a new suburb are willing to pay more for bus service than this service would cost. If an individual were in charge of deciding whether or not to start service, and if he or she were also the sole claimant to the residual, service would be provided because the individual would reap the difference between the gains and the costs. Moreover, such a service would be expanded until, on the margin, the cost equaled the gain. In a political system, given the way such systems usually operate, the effect of demand forces is less direct, but it is definitely not absent. The system of rewards in government seldom compensates individuals for the full private gains they generate. An operator in the political realm unable to claim 100 percent of the residual would stop short of the level of service a private operator would reach. Although the same forces that bridge gaps created by price controls tend to prevent gaps between marginal valuations and marginal costs from growing ever larger, a full-fledged residual claimant is less handicapped than one who has only a partial claim; the full-fledged claimant will consequently produce what appears to be a more efficient outcome. Why would an operator not be allowed to claim 100 percent of the residual? More generally, why are individuals not always allowed free rein to become residual claimants? Prohibitions must perform real functions. The superior who has constrained the operator presumably has the power to impose constraints.14 Returning to the example of suburban bus service: The superior may have had no interest in increasing the operator’s wealth but could still have been able to increase his or her own wealth by selling the right to serve the suburb. In order to answer the question regarding the absence of a full-fledged residual claimant, one must also ask what prevented the superior from selling the right to the operator or, even better, to the highest bidder. I conjecture that the answer lies in the fact that the seller’s wealth depends not only on the pecuniary price but also on features of the buyer and of the exchanged property. In general, maximizers may choose not to sell an asset or a franchise to the highest bidder. There are many reasons for this reluctance, all of which may be viewed as resulting from the presence of side effects. For instance, manufacturers sometimes pay their salespeople a commission or a salary instead of selling them the merchandise outright. By not granting salespeople 14

For simplicity, the superior here is assumed to possess the ultimate authority; people intermediate in the hierarchy are ignored.

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full residual-claimant status, manufacturers ensure that their incentive for capturing wealth from other salespeople is tempered. In another case, persons who cannot fully guarantee their actions may be inclined to take unduly large risks. The incentive to undertake excessively risky projects where some of the risk is borne by third parties is reduced if the decision makers are not allowed to become full-fledged residual claimants. One reason residual-claimant rights are not granted may apply primarily to despotic regimes. The explanation has to do with the concentration of wealth that free enterprise entails. Bad luck may cause the holders of residual claims to experience financial ruin, whereas good fortune can render them rich. When many opportunities to assume residual claims are made available, at least a few individuals are likely to become rich. Rich people, particularly those whose wealth is not easy for others to keep track of, are in a position to finance coups. Such people pose a threat to the despot. This is likely one reason why dictators are often averse to free enterprise. Communist regimes’ harsh treatment of “profiteers” may be a case in point. The suppression of opportunities that may enrich some individuals is costly to dictators, who could, instead, allow their exploitation while collecting a commensurate franchise fee. It is not that dictators are not assumed to be maximizers. Their longevity and the security of their status are what is viewed as valuable to them. They are willing to sacrifice pecuniary gains they could otherwise obtain by auctioning off various residual rights, because these would have posed a risk to their security. Instead, they prefer to operate bureaucratically – a less lucrative option but one that promises greater longevity. The distinction between the private and public sectors is not to be equated with that between the presence and absence of private property rights. Such rights are necessarily present in both systems. The distinction lies instead in organization, particularly in the incentives and rewards under which producers tend to operate. In the private sector, producers have the opportunity to assume the entire direct effect of their actions. In the government sector, people assume a smaller portion of the direct effect of their actions. Both systems reflect the outcome of the actions of maximizers, and both must operate efficiently. CONCLUSION

It is common for economists to err on the side of markets, prices, and private individual ownership. This after all, reflects their default neoclassical world view, where prices work for free. Market allocations based on prices do not work for free, however, and this means that other (costly) non-market allocation systems can compete with them. Whether through such things as families, voting, charity, or governments, the form of organization that is observed maximizes wealth net of the transaction costs involved. The economic problem is one of choosing the appropriate allocative mechanism for the particular circumstances at hand. Often this means that markets are not chosen, but rather some non-price alternative.

14 Additional Property Rights Applications

INTRODUCTION

In previous chapters, the property rights approach was used to explain various aspects of such specific phenomena as gasoline price controls, private roads, and homesteading, and to develop a general approach to, among other things, non-market allocation, the maximizing role of restrictions on property rights, and, in the context of farm tenancy, the choice among various forms of control. The property rights framework can be applied to other problems as well. Here, we briefly consider several of these problems, beginning with an analysis of the individuals’ ability to protect themselves against losses to monopoly, proceeding to a discussion of the relationship between property rights and theft, of property rights in relation to innovation and to price information, and concluding with an exploration of property rights as they relate to wildlife. PROTECTION AGAINST LOSSES TO MONOPOLY

Monopolies are said to result in resource misallocation, which takes two forms.1 The first and better-known type of misallocation arises because monopolies produce “too little,” charging prices that exceed marginal costs, whereas the second type arises in the process of creating monopolies. Would-be monopolists spend resources in order to attain monopoly positions, and such expenditures are dissipating. The magnitude of these capture costs is comparable to that of the expected profits of the monopoly. Naturally, monopolists have economic rights to whatever gains they obtain. Since monopolists’ gains exceed their contributions, their gains occur at the expense of others; thus, they also seem to have the right to harm other people. Yet such rights are not

1

A more detailed discussion of this problem may be found in Barzel 1994.

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exercised indiscriminately, and it is worthwhile to determine the circumstances under which such power is likely to be used. In general, a property that can be captured must lie, at least in part, in the public domain. Moreover, what lies in the public domain must have been relinquished by the previous owner. In the case at hand, if someone is able to capture a monopoly position or, more accurately, if someone is able to, at a cost, capture the rights to the monopoly gain, then the monopoly position itself must have been lying in the public domain. In order for these rights to have entered the public domain, individuals must have relinquished them in the first place. Consider under what conditions would individuals allow this to happen where monopoly is attained by predatory pricing? In predatory pricing, an initially competitive industry is taken over by a predator, who monopolizes it by temporarily pricing the target commodity at less than it costs, thereby forcing the competitive producers to leave the industry or to sell their facilities cheaply to the predator. This method illustrates the general principle behind opportunities for capturing monopoly gains.2 In the competitive industry that existed before predatory action, consumers were able to purchase the target commodity from many sellers at a competitive price; this ability is threatened by the predator. Recalling that economic property rights are defined as an individual’s ability to exercise choices over goods, it seems proper to ask what gives consumers the ability to obtain a good at the competitive price. Anti-monopoly laws aside, consumers surely do not have a legal right to the competitive price. Consumers, however, can acquire the legal rights – and consequently the economic rights – by the simple expedient of signing long-term, competitively priced contracts for the commodity while the industry is competitive. They might choose to commit to such long-term contracts if they fear monopolization by a predator. Long-term contracts will also benefit the competitive sellers. It is difficult to ruin sellers who have signed such contracts, since they do not have to sell all their output at the predatory price; for the same reason, they command a high acquisition price from the predator. As long as the extra costs of arranging long-term contracts over and above those of spot exchanges are less than the perceived loss to monopoly, threatened sellers and consumers will gain by establishing rights to supply and to be supplied, respectively, at the competitive price.3 When the cost of protection, whether through long-term contracts or any other means, is less than the expected loss to being monopolized, the would-be monopolist cannot gain 2 3

We take no account of the controversy surrounding the logic of, and the evidence for, predatory practices. The successful predator will gain more (in present terms) from the ultimate monopoly pricing than they will lose from below-cost pricing during the predatory period or from buying out competitors at terms attractive to them. Conversely, consumers and preyed-upon firms will be the combined net losers from such predation, and it seems highly probable that consumer losses from the monopoly price will exceed their gains from the initial lower price.

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from the monopolization and therefore will not attempt it. In this sense, the would-be predator does not possess the right to such a gain. Since the total losses the would-be monopolist inflicts on others exceed their gain, as long as contracting costs are not high, the rights competitive buyers and sellers possess tend to be secure. Assuming that in the absence of defensive action the predatory practice is a real threat to competitive buyers and sellers, it is expected that the less costly it is to arrange long-term contracts in an industry, the less likely it is that the industry will be subject to monopolization. In summary, the ability of consumers and competitive sellers to exchange at competitive prices depends on their own efforts to enforce the appropriate arrangements. By and large, they are expected to be successful because monopoly tends to be “dissipating” in the sense that the monopolist’s gains are less than the costs they impose on others. Still, when enforcement costs are high, consumers’ and sellers’ rights to be served at the competitive price are likely to be relinquished, and a predator may then capture the right to a monopoly position.4 PROPERTY RIGHTS AND THEFT

The existence of theft makes the distinction between economic and legal rights clear; it also highlights the notion that economic rights are never absolute. Thieves lack legal rights over the goods they steal. Nevertheless, they are able to consume the goods, to exclude others from using them, to derive income from them, and to alienate them. Each of these rights is a component of ownership. The lack of legal rights reduces the value of these economic rights, but it does not nullify them. The fact that thieves have economic rights over stolen property implies that the current legal owners of property that might possibly be stolen do not have perfect property rights over “their” property. Owners cannot be certain of the future use of such commodities. The economic rights they do have depend, in part, on the protection effort made by the state. These rights also depend on the measures owners take to protect themselves from theft: The more they are willing to spend, the more secure their rights are expected to become. The effort they make, however, is not expected to deter all theft. For instance, fences around orchards are not totally insurmountable; the cost of making them insurmountable exceeds the gain. Here, too, individuals choose to leave some rights in the public domain. When the probability that thieves will steal one’s apples is positive, then one has only partial ownership over the apples. Private-protection methods are as varied as are commodities themselves. Owners of apple orchards may employ guards to reduce theft; they may place trees farther from their property boundaries than they would in the absence 4

Alternatives to long-term contracts also exist. One is that it may be possible for consumers to purchase the firms and operate as cooperatives.

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of theft; and they may grow less valuable apples that are less appealing to thieves. Indeed, landowners might grow entirely different crops if theft became a serious problem.5 Those owners who wish to employ others to tend their orchards may fear employee theft. Changing a contract’s form is expected to change the incentive to steal. If, for example, an owner forms a fixed-rent contract with a worker to tend the orchard, the problem of the worker’s theft simply disappears. The notion that imperfect property rights is a manifestation of theft can be illustrated by reconsidering movie theaters. Of the attributes theater owners relinquish to the public domain, two relate to the difference in value among seats. The first relinquished attribute is the difference in value between the better and the inferior seats within a price class of seats. People can capture the difference in value by arriving early and occupying the better seats. To the extent that policing is imperfect, a second attribute that is partially relinquished is the difference in value across price classes. Where seats are sold in several price classes, as is common outside the United States, buyers of lower-priced tickets can capture the difference to the extent that they are not prevented from occupying higher-priced seats. The state takes part in the enforcement effort only in the latter case, since jumping seats constitutes a legal infraction, whereas selecting a certain seat within a price class obviously does not. The economic logic of the two types of capture, however, is the same. PROPERTY RIGHTS TO INNOVATIONS

In contrast to other areas in economics, the importance of property rights considerations to innovations has been widely recognized by economists; nevertheless, some major rights issues remain unresolved. One such issue concerns the economic rights innovators can expect to have over their innovations. When a uniquely talented individual develops an innovation, it seems plausible that such an individual will be able to obtain the rights to it, since they will control the field. On the other hand, if many individuals are able to develop the same innovation at a similar cost, it may appear that none has a right to it and that, in their competition for the gain from the innovation, its economic value will be dissipated; nevertheless, in this case rights may also be well defined. A useful measure of the net present value of an innovation is the difference between total consumers’ valuation and total innovators’ costs. Each of the potential patterns of activity leading to a particular innovation will generate its own net present value. The highest value will be generated by the innovative activity that satisfies two conditions: that it be free of duplication and that it be undertaken at the time that yields the highest consumer valuation net of innovating costs. One market force that tends to bring about the 5

Reportedly, some avocado orchards in the San Diego area have been abandoned because of increased theft.

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realization of these conditions is competition among innovators in recruiting customers for their particular innovations before expending resources on the actual innovation.6 In order to attract potential customers away from competing innovators, not only will innovators tend to cede to customers the bundle of all the gains from the innovation but the winning innovator will also be the one who performs the innovation activity closest to the time that maximizes its net present value; only then can the bid for customers dominate that of competitors. When the cost of recruiting customers, whether directly or indirectly, is low, customers have, in practice, the rights to the gain from the innovation. As in the case of predatory practices, the easier the advance contracting, the better the delineation of rights. Innovators who possess unique talents do not need to cede to customers all the potential gains the innovations generate. Such innovators may encounter another problem, however. Every customer may try to obtain a bargain by offering the lowest royalty payment. Since the innovators’ marginal cost of serving extra consumers is zero, they may be willing to relinquish ground rather than lose customers. Individual incentives for bargaining under these conditions implies that the difference between the maximum consumer valuation and the marginal cost lies in the public domain. The potential loss from such bargaining can, however, be lowered if the parties can be compelled not to bargain. Therefore, if the option of selling the use of the innovation to different consumers at different prices can be eliminated, either privately or through legal prohibition of price discrimination, then the innovator’s rights over the innovation will be partially restored. Maximizing sellers will equate their constrained marginal revenue to their (zero) marginal cost and will price accordingly. The superimposed uniformity of prices – royalty rates in this context – delineates rights, and their determination is free of direct capture costs. This arrangement is not entirely free of cost, however, because when a single price is prescribed, the welfare triangle that could have been avoided under price discrimination is relinquished to the public domain. PROPERTY RIGHTS , MONEY, AND BITCOIN

Every society that has existed has used “money.” Money is an intermediate medium to an exchange, and so when one good is ultimately exchanged for another, there are extra exchanges in the middle where goods are traded for “money.” If we returned to the zero transaction cost world of Chapter 1, where all things are known at zero cost, there would be no need for money. The exchange of any set of goods would take place at known prices without a medium of 6

Yu (1981) discusses at length methods used for such recruiting. Demsetz (1968) was the first to consider advance contracting for selling commodities whose production is subject to declining costs.

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exchange. In order to get what was wanted, one might have to engage in a series of exchanges, but with zero information costs, this could easily be accomplished. Money, therefore, requires the existence of costly information and the subsequent transaction costs that result. Money is a means by which these transaction costs are (greatly) reduced. There are two significant transaction cost problems that money addresses. First, as we have noted many times, trade requires goods to be measured and measurement costs reduce the value of exchange. If someone trades a cow for a horse, each must be inspected to determine their value, and this lowers the net value of the trade. Alchian (1977) pointed out that if a commodity existed that had a low cost for everyone to measure, then that commodity will tend to function as money because it lowers the costs of measurement for every transaction. Thus, although anything could be used as money (cows, rocks, sticks), the commodity used is the one with the lowest costs of measurement, other things equal. Low measurement costs must remain over time, and so the good used for money should be “stable,” and not be subject to manipulation over the life of the exchange. Historically, gold and silver were used as money because they are relatively easy to measure, and difficult to manipulate without detection. Second, trade often requires some type of commitment because exchange often involves sequential trades over time. Imagine a series of trades that took place using a set of complicated accounting books, keeping track of the debits and credits of each trade. At the end of the day, as long as everyone fulfilled their promises, the books would clear. This would not just be a costly system, it would also be a situation where those who relinquished their goods early in the day would remain in jeopardy until the expected goods are received later. Trade would require massive self-enforcement and/or state involvement. The use of money avoids this problem since all sequential exchanges are cleared immediately. As long as each person trusts that the money will be accepted, the commitment problem is solved. Commitment, again, is only necessary in a world of positive transaction costs. As some have noted, “evil is the root of all money.”7 Money, if we think only of central bank notes, is a low measurement cost system of anonymous bookkeeping. Money could be replaced by an alternative system of policed accounts that recorded all transactions between all identified traders, such that at the end of the day, goods ended up being consumed by those who most valued them. Such an accounting system would be incredibly burdensome. Imagine the detail of recording and verifying all of the exchanges that took place in the smallest of contexts. Imagine authenticating the ledger and ensuring that it was not tampered with. Money, solves this problem, and when the good used for money is easy to measure, it solves it at a remarkably low cost. Money has evolved over time and modern societies have long moved from physical commodities used as money (gold, silver) to forms of fiat paper 7

See Kiyotaki and Moore (2002).

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money, digital bank deposits, and other electronic money. Such fiat systems, however, are subject to other transaction cost problems, and these are often managed by institutions such as central banks, intermediary reputations, treasury departments, law enforcement, and other political offices. When these do not function well the consequences can be disastrous, as many hyper-inflations have shown. Partly as a response to issues related to the transaction costs of fiat money (inflation taxes, high fees, lack of privacy), new money has been invented over recent years. Most notably Bitcoin was launched in 2009 as a decentralized cryptocurrency, with the intention of making financial transactions anywhere in the world as easy as sending an email. Bitcoin relied on several cryptography innovations that began in the late 1970s. The first was by Diffie and Hellman (1976), which created a “key exchange” that allowed people to share private information across an insecure network like the Internet. The second was by Rivest, Shamir, and Adleman (RSA) (1977) which created a public-key cryptosystem that allowed for both private and public keys to encrypt and decrypt messages. Together these allow two parties to prove they are who they say they are, that their message is authentic, and no one can deny it was them (or their card). They form the backbone of internet banking and online payment systems; they create a new type of identity where someone can be anonymous, but identifiable; and they allow for “digital signatures” which can be bound to any electronic message. Digital signatures can be alienated and therefore traded in the form of nonfungible tokens (NFTs). But how does one know that the seller of an NFT did not sell it a second time? A third party could verify, but who is to trust the third party? Enter the “blockchain.” “Blocks” are essentially fixed-sized ledgers of trades that identify the distribution of ownership. As trades take place, they are added to the block until it is filled up and then linked to a new block. Volunteers, known as miners, act as decentralized auditors to verify and clear the transactions. They are paid in bitcoin along with a service fee. Bitcoin, Ethereum, Tether, or one of the thousands of other cryptocurrencies, although novel, are ultimately fiat money substitutes that are solving the same basic transaction cost problems. Although the originator of Bitcoin had hoped it would be used for small transactions, like buying a bran muffin and a cup of coffee, in most of the western world, it has not turned out that way. Bitcoin transactions are slow, taking up to ten minutes to clear, and each block contains only about 2000 transactions. Far too cumbersome for most North Americans, unless one is making a black market trade that requires secrecy, trust, and anonymity. Interestingly, cryptocurrencies are used far more often in countries where there is little trust in the banking system or the state’s ability to manage the currency. For example, in Argentina there have been periods of hyperinflation broken up by periods of high inflation for over thirty years. The government

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has imposed strict capital controls and exchange taxes that make moving money in and out of the country difficult, and foreign exchange rates are regulated by the government. In such a context, a cryptocurrency like Bitcoin, despite its problems, becomes an attractive alternative to government fiat money. PROPERTY RIGHTS AND PRICE ESTIMATES

Coase (1937) notwithstanding, economists seldom realize that determining which prices will clear the market is a resource-consuming activity. Were such prices easy to determine, no serious errors in setting prices would occur, yet significant pricing errors are widespread. Some concerts, for example, are poorly attended, whereas tickets for others can be obtained only from scalpers. Likewise, some artists sell out at their gallery openings, but others see an entire show go by without selling a thing. Last, some new stock offerings are instantly snatched up, while others turn out to be duds. Such examples suggest that setting prices correctly is costly. Providing price estimates is costly as well and must generate a reward; since the estimates are subject to error, speculators may capture the value of the difference. Resources will be spent both on the capture of price information and on the prevention of such capture. It might be expected that prices would be set by individuals who specialize in doing so, yet on examination the direct sale of price estimates proves problematic. If the producers were to purchase price estimates for their commodities, they would also require a guarantee of the quality of the service they were buying. Some of these commodity producers, however, could take advantage of the guarantee by lowering product quality and shifting part of the guarantee burden to the pricing specialist. This difficulty may be avoided if the producer of the commodity also sets the price, which might explain why the two activities are often performed within the same organization. Some commodities and services are not as susceptible to the problem of guarantee abuse as others, and for these the producer of the price estimate may guarantee their service, thereby becoming the residual claimant to variability in the value of the service. An important example of the provision of price services by independent specialists may be seen in syndicates of investment bankers, which advise business firms about the price at which to sell new stock. At the heart of the transaction between a syndicate and an issuer of stock is the implicit price guarantee. Essentially, a syndicate buys the entire stock flotation at the agreed-upon price and offers it to the public at a price not exceeding a predetermined ceiling. A syndicate that errs by overestimating the marketclearing price will be the one to bear the effect of its error. The syndicate, then, maintains the property right to its price estimate. Pricing errors may have an additional effect on behavior. The ultimate buyers of a new stock may either rely on the recommendation of the syndicate or devise their own (or use their advisers’) estimates of the market price of a

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stock and act accordingly. The latter action constitutes a duplication of effort, since the information is a public good that has already been produced by the syndicate. The lower the costs associated with acquiring a stock, the greater the demand for it; the demand is also higher if buyers believe that, on average, their suppliers offer them bargains. They cannot, however, expect every new stock to be a bargain. Since some stocks are expected to be duds and others are expected to be bargains, buying only the latter and avoiding the former would be highly profitable. Information on new offerings that allows a speculator to avoid some of the duds while concentrating on the bargains should enable them to earn a positive return. Success by such a speculator, however, will lower the return to uninformed buyers; they will be forced to buy relatively more duds, since a relatively large fraction of the bargains will already have been purchased by the speculator. The demand for stocks by buyers who do not acquire information on individual issues but who are aware of the average return on new stocks will be lower when they must compete with speculators, resulting in lower stock prices. In order to protect their rights from being captured by speculators and to prevent an adverse shift in the demand facing them, syndicates must deter speculators from acquiring information. This may explain the restrictions on the number of shares of a new issue individuals or organizations are allowed to purchase. If would-be speculators can use their information to buy only small blocks of shares, they will seldom find the information worth collecting. Thus, the restriction seems to protect the rights of syndicates to their costly price information.8 PROPERTY RIGHTS TO WILDLIFE

Wildlife, by its very nature, is ... wild; in its extreme form, wildlife is unowned and in the public domain. As such, it seems incongruent to speak of property rights to wildlife.9 Nevertheless, a wide range of property right systems govern the use of wildlife, and these systems range from complete open access to private property. These governance structures create value to the wildlife net of the transaction costs of creating them. The key to understanding the distribution of property rights to wildlife is to realize that they are an attribute of land, and therefore ownership over habitat is closely related to ownership of the wildlife. It would be simple to let one person own the entire habitat of a wildlife stock such as a herd of deer. Indeed, some large hunting ranches in the United States do contain the entire habitats of several wild animals, and some huge African game preserves are home to whole herds of many different species. Seemingly, 8 9

Th section is based on Barzel, Habib, and Johnsen (2006). They argue that investment banking syndicates are designed to avoid information collection for the purpose of wealth transfers. The discussion in this section borrows heavily from Lueck 1995, 2010, and 2018.

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the reason these ranches are so large is to encompass entire habitats. Likewise, many primitive societies seem to have owned the entire habitat of the wildlife stock they hunted or fished. A wildlife stock that occupies and traverses a land area is only one of several attributes of the land; the others include the capacity for growing wheat, yielding minerals and groundwater, residential and business use, and offering scenic vantage points, as well as providing habitat for wildlife. Each implies a distinct parcel size and shape for optimal use. Wildlife stocks themselves are diverse, varying greatly both in value (pests being negatively valued) and in the size of the territory they occupy. Were transaction costs zero – and taking account of the interactions among the attributes – each would be optimally exploited and, consistent with the Coase Theorem, the ownership pattern would be irrelevant. Since transaction costs are positive, the ownership pattern matters. The ownership by single persons of entire habitats of migrating birds that travel across vast areas or jurisdictions, and of wildlife stocks that cover a wide swath precludes the ownership pattern that accommodates many small farms and other efficient-size land holdings. Given the theory of property rights, the expected ownership pattern of land should conform primarily to the most valued use of the land. Prior to contact, the Great Plains tribes that relied on the bison defined their territory based on the bison habitat (Lueck 2018, p. 157). In most cases, however, the ownership pattern of land does not match wildlife habitat, suggesting that the non-wildlife uses of the land are more valuable. In general, the individual economic property rights to wildlife should be stronger as net value of the wildlife increases. This could occur because the wildlife is very valuable or because the transaction costs of managing the wildlife are low. When this net value is low then governments may be able to establish some rights to wildlife that maximize their second-best net value. This often takes the form of regulating access to the wildlife public domain. The current legal doctrine governing wildlife in the United States assigns the regulation of wildlife and its partial ownership to the states and sometimes to the federal government. Private individuals are also legal owners of some wildlife attributes, as well as being the economic owners of many of them. The allocation of rights to wildlife in Canada is similar to that in the United States. In England, however, these rights are mostly assigned to private individuals. The difference is consistent with the hypothesis that these governments attempt to maximize the value of wildlife. Although the population density in England is considerably higher than it is in the United States and Canada, the average farm size is much larger in England than it is in the United States and Canada.10 The habitat required to support the most valuable wildlife stocks in these three countries displays the 10

For example, according to Lueck (1989) “in 1899, the mean farm size in the United Kingdom was 390 acres; it was 134 acres in the United States” (p. 312), and “private landholdings are even smaller and more scattered in Canada than in the United States” (pp. 316–317).

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opposite pattern. Large mammals are rare in England, and game birds and fish tend to be local there; whereas in the United States and even more so in Canada the habitat of large mammals is vast, and many game birds and fishes migrate long distances. Whereas English law is the basis of law in the United States and Canada – law in the latter two, especially Canadian law, still has much in common with that in the former – the wildlife components of the American and Canadian laws diverge drastically from the English ones. In England, where holdings are large and wildlife habitats are modest, wildlife is controlled by land owners rather than by the state to a great degree, individuals holding the bulk of the rights to it. In the United States and Canada, the law is much more restrictive regarding the rights to wildlife individuals have, and the states, provinces, and federal authorities retain a much greater regulatory power than do their English counterparts. For example, the restrictions on the length of the season, the bag limit, and the trade in wildlife products are much more severe in the United States and Canada than they are in England. It is worth noting that within the United States and Canada, the rights retained by the states and provinces are relatively more local than those assumed by the federal authorities. Moreover, consistent with the notion that the purpose of the regulations is to maximize the value of wildlife; private ownership to wildlife in game farms and fish ponds is routinely granted. Whereas in the absence of government regulations, much of the roaming wildlife in the United States and Canada would be common property, the law reduces the overexploitation of such wildlife, thereby increasing its value to individuals. The need for such laws and regulations is much reduced in England, where individuals’ land holdings conform quite closely to wildlife habitat. Lueck (2018) describes Native American ownership over wildlife and notes how similar it was to modern government regulation. Tribes controlled wild stocks by limiting access and timing of harvest, and they often held rights in common, which incentivized members to police poachers. When Europeans began to encroach on the territories they destroyed the existing property right systems and created truly open access to major species like the bison. This led to rapid declines in many wildlife populations. Eventually, most bison came under private ownership of individual land owners and became managed like other domesticated animals. Most of the bison currently in North America are privately owned (Lueck 2018, p. 167). The case of wildlife shows that even in situations where the transaction costs of establishing private property are very high; an unregulated open access public domain is not the only alternative. Across different species, a series of complicated ownership structures are used to create value to wildlife. These distributions of property rights, as always, depend on the level of gross wealth generated and the transaction costs of those particular arrangements.

15 The Property Rights Model

INTRODUCTION

It is common in economics to read of “institutions and organizations,” especially in terms of economic growth and the divergence of per capita incomes across nations. It is also common to read of “institutional analysis,” “institutional economics,” and “organization theory.” And of course, the terms “property rights” and “transaction costs” abound. Most often, these things are defined and connected only vaguely. Indeed, often one reads phrases like “property rights and transaction costs” as if there was no functional relationship between the two whatsoever. The purpose of this book is not to build on top of the large work done in institutional economics, but rather to examine its foundation. That foundation is the concept of “economic property rights,” and we have argued that it is the base unit for an analysis of the study of resource allocation and the organization of trade and production. Decisions are made by individuals in the process of maximizing the value of their economic property rights. These rights are functionally related to transaction costs and depend on legal and natural rights, among other things. We have argued that systems of legal and natural rights can constitute an institution, and more importantly, that institutions have effects because they functionally influence individual economic property rights. By focusing on economic property rights and examining their complexity in terms of their division over attributes, incompleteness over rights, and strength in terms of perfection, we have opened up the “black box” that is so often used in economic treatments of the subject. Examining the detailed nature of economic property rights leads to an understanding of why and how wealth changes when property rights change, how often rights become more incomplete as wealth increases, and that the critical feature of property rights and wealth is in terms of property right strength. 254

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Although our purpose is to lay out these fundamental features, we have exploited these concepts to discuss and analyze contracts, organizations, and institutions. We have also examined a series of examples of behaviors and organizations that bring out the implausibility of the world described by the neoclassical model. These examples have included discussions of the family, slavery, homesteading, wildlife, waiting and racing, blood donations, theft and police, government provision, voting, water rights, and private roads. When transaction costs are positive, “privatizing” goods and engaging in pure market transactions does not always enhance net wealth; whereas placing goods in the public domain or engaging in non-market forms of allocation, can be net wealth enhancing. A RECAPITULATION

Goods are made up of numerous attributes. People have discretion over how to divide these attributes, separate rights over them into different bundles, and enforce those rights. As part of their maximization effort they do so to whatever degree they desire, subject to the constraints they face. The act of dividing, separating, and enforcing rights is never perfect, however, because commodities are not uniform and are expensive to measure on all dimensions. Nevertheless, since people do what they deem “best,” for themselves, property rights may be said to be always optimally defined. Those attributes, commodities, or properties that people choose not to own lay in the public domain. Such things include much of the world’s oceans; they also include the cool air in air-conditioned shopping malls, which is not charged for on the margin, as well as for underpriced supermarket commodities at rush hour. Those things are placed in the public domain as a matter of choice and can be augmented or diminished. As the values of commodities and of commodity attributes change, and as the costs of dividing, separating, and enforcing rights over them change, people’s decisions regarding what to leave in, what to relinquish, and what to reclaim from the public domain change correspondingly. The public domain is ubiquitous; innumerable commodity attributes are placed in it. Any service not fully charged for on the margin is at least partly relinquished to the public domain. Owners could charge for such services, but the extra returns often do not justify the extra costs. Because resource owners maximize the net value of their resources, they organize their actions so that, ceteris paribus, they mitigate the losses from placing attributes in the public domain. These mitigation activities come in many forms and manifest themselves in the various contracts and organizations that we observe. Exchange is a process of transferring economic property rights, and to gain from this process, people must spend resources to assure the correct cession of rights take place. These efforts are costly and constitute one of the many forms of transaction costs. For a given exchange, contracts are structured so

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as to mitigate these transaction costs. One means of doing so is through the choice of units by which to regulate the transaction; for instance, labor can be exchanged by the hour and rewarded by a wage, by the month and rewarded by a salary, or by the unit and rewarded by a share in each piece. The use of each of these units relinquishes different subsets of attributes to the public domain, for example, the per-hour effort when labor is sold by the hour or the care or quality of the output when labor is sold by the piece. In addition to having a choice of units, contractors may alter the completeness of property rights of each individual – transferring specific rights from one party to the other. This often comes in the form of imposed restrictions on the way the exchange is conducted in order to reduce the amount spent to capture from each other. As noted, a sale subject to a warranty often prohibits certain uses of the product (e.g., commercial use) while requiring other actions (e.g., servicing). Such restrictions mitigate usage that exploits the unpriced attributes of the other party. The more valued transactions are, the more attributes are expected to be priced and measured, or the more comprehensive the restrictions are expected to be. Since exchanged commodities are not uniform and are not fully measured, the value of the exchange is variable. The distribution of property rights within a contract necessarily allocates this variability among the transactors. As transactors alter the units of exchange, they also alter the associated restrictions, specify the margins on which residuals are born and by whom, and they divide the variability in outcome among themselves. They choose that allocation of variability which maximizes the net wealth of the exchange, and this will tend to assign variability to the one who most affects the value of the mean outcome of the transaction. All exchanges, with the minor exception of some governed by caveat emptor, require organization. In cases subject to caveat emptor, buyers need assurances that they will not walk away with worthless merchandise. If buyers check the exchanged items directly, the degree of organization may be trivial. Not trivial, however, is the resource cost of such exchanges. Non-caveat emptor sales, that is, sales in which the transactors have imposed constraints on each other, require real organization in order to police and to monitor the constraints. The nature of, and the costs associated with, such organizations vary with the pricing method used. A sufficient change in conditions, such as a change in the valuation of the transacted commodity, will change the method by which the commodity is sold, as well as the organizational structure governing its exchange. Exchange often takes place at posted prices, and the property rights model implies that whichever party can better predict prices will be the one to post them. Whoever posts a price is subject to exploitation; their exchange partners may engage in excessive price prediction, discover prediction errors, and take advantage of the willingness to deal at a fixed price. It is further implied that the person who can more readily predict the price will be the one who will have to assume the consequences of posting it. Price prediction is subject to

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economies of scale; the more units traded at that price, the lower the unit cost of the prediction. Thus, as the size of the buyer vis-à-vis the seller increases, the more likely are buyers, whose unit cost of prediction has declined, to post prices at which they agree to purchase what sellers wish to sell. Because all but the lowest-value transactions are subject to constraint and require organization, only a small fraction of transactions are purely “in the market,” as this term is usually understood. The frequently asked question as to which transactions will take place in the market and which will remain within the firm is not likely to receive a useful answer, however. Firm transactions are not uniform, and some of them are more “in the firm” than others. A more fruitful question concerns the determination of the forms of organizations that will govern different kinds of transactions and of the forces that will bring about change to these organizations. The complexity of commodities and activities causes ownership patterns to be complex as well. The most efficient owner of a particular commodity attribute is not necessarily the most efficient owner of the commodity’s other attributes. It may be advantageous to divide the ownership of a commodity among several individuals. Such is the division of ownership of rental apartments between the owner who retains the rights to the common areas, and the tenants who become the owners of various features of the apartment they rent. Because the commodity is itself not physically split, each owner, if not properly constrained, may find it easy to consume some of the others’ unpriced attributes. Organizations, including business firms, typically engage in a multitude of activities, including policing and monitoring constraints. In the case of the business firm, many factors affect the variability in its income. The price of each commodity it buys or sells can fluctuate, each specimen of the commodities it exchanges may differ from others, and its income may depend on whether or not such phenomena as fires, earthquakes, and foreign confiscations occur. Each of these instances of income variability may be borne by a different party. A firm may purchase a raw material on the spot market, or it may operate under a long-term, fixed-price contract for it. Assuming no breach of contract, in the former case the buying firm bears the effect of fluctuations in the price of the commodity; in the latter case its contract insures it against fluctuations. These considerations apply to all the firm’s sources of variability. In each of these instances it is expected that the party that is better able to affect the mean outcome will tend to assume the associated variability. For example, it is expected that a raw-material supplier that has some power to set its price is more likely to sign fixed-price, long-term contracts than one not possessing such power. Similar considerations apply to labor services. Workers, who can affect outcome-value more easily than the purchaser of the labor services can, are likely to operate as independent contractors selling output rather than labor. At the other extreme, purchasers of labor services will assume variability in outcome by paying a fixed wage on a long-term basis. It is to be expected that as

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the market wage of workers rises, they will gravitate toward self-employment (Barzel, 1987). When two parties agree to a formula for dividing future income variability, one may emerge as the winner and the other as the loser as the outcome of the transaction unfolds. Because the loser could gain by reneging on the contract, each party demands assurances from the other that the contract will not be breached. A necessary though not sufficient condition for such assurances is that a party be able to meet their obligations. Fixed-wage suppliers of labor can readily guarantee performance even when the market wage exceeds the contract wage, because they own their labor services. The employer of such workers must be able to ensure wage payment when the market wage falls below the contract wage. Equity capital specializes in providing such assurances. More generally, it seems that equity capital is assembled (and augmented) in order to guarantee all the contracts signed by the firm. These contracts may, in turn, be viewed as constituting the firm; in this sense shareholders are the owners of the firm, and the firm is a “nexus of contracts.” In most instances of human interaction, standard transaction cost issues may arise. This interaction, in and of itself, may generate social benefits beyond the interacting parties. Furthermore, the act of resolving these transaction cost problems may also provide benefits to other individuals not party to the particular interaction. This means that some outside set of forces may have a comparative advantage in encouraging the interaction and resolving the transaction cost problem most effectively. These outside forces or systems can broadly be thought of as the legal and natural rights, which contain all of the formal and informal rules, norms, values, and social expectations of behavior that we call institutions. Institutions are important because, as exogenous constraints on individual economic property rights, they help determine the level of wealth that can be achieved in a given context. Institutions help regulate the division, completeness, and perfection of property rights. Institutions themselves are a matter of choice, and also subject to analysis through the property rights model. All forms of human organization then, can be thought of as various distributions of economic property rights across people. The theory of economic property rights states that these distributions maximize wealth net of transaction costs. How this is achieved, whether spontaneously, through some process of natural selection, or through design is a secondary issue for us. The primary goal of the theory is to explain the pattern of ownership observed. CONCLUSION

We have demonstrated how the property rights model can generate a better understanding of the allocation of resources and of the interaction of this allocation with economic organization. The literature that assumes that the costs of transacting are zero and that all property rights are perfectly well delineated

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259

is incapable of dealing with a vast array of actual observed practices. Particularly glaring is the inability of such an approach to explain the nature of how any exchange is organized. Often organizations include self-imposed restrictions on those engaged with each other. The property rights approach is capable of addressing such issues. Many approaches to the analysis of economic behavior do not explicitly assume that transaction costs are zero, but they also do not inquire as to what the precise rights of the parties are. It is our impression that economists who neglect economic property rights considerations are prone to making implicit assumptions that are often not well taken, while producing results that are hard to accept. It is quite common to find discussions where within single models some transaction costs are implicitly assumed to be zero, while others are assumed to be prohibitively expensive.1 The approach that insists on asking who owns every particular attribute of a commodity and what “owners” can actually do with “their” commodities addresses the root of transaction costs and is, therefore, less likely to fall prey to untenable assumptions. Finally, consider the application of the property rights approach to the distribution of gains from trade. Many goods are valued less by their current owners than they are by other individuals. Who owns these potential gains from trade? In the competitive, zero transaction cost model, the distribution of the gains is costlessly determined. The costless information (or the uniformity of commodities) necessary for such competition is, however, seldom encountered in reality. Opportunities for people to gain at the expense of others seem ubiquitous. Whereas individuals are always ready to expend resources to increase their share of the pie, they will also seek out methods and organizations by which to better delineate rights to it, thereby dividing the pie without shrinking it too much. A considerable portion of this book has been devoted to analyzing such behavior. It is fitting to conclude by visiting one unlikely place where the time and effort of haggling over the distribution of the gains from trade are effectively avoided: an Egyptian bazaar. ... (in Cairo’s) principal livestock market, camels take center stage. ... [T]he camel market’s own King Solomon [is] Muhammad Abd al-Aziz. ... Sales are conducted one-on-one — one buyer, one seller and one camel at a time. ... With an acutely discriminating sense of camel flesh [Muhammad] sets a fair price. ... His authority is usually sufficient to settle any difference. (Werner, 1987, p. 132)

Transaction costs are low in this particular market. Muhammad possesses much of the desired information as well as the trust of the transactors. Nothing, however, comes free. Here, the cost in question is “a small margin for Muhammad’s commission.” 1

For example, in many information asymmetry models one set of individuals is, as a rule, implicitly assumed to be costlessly informed, while for others the information cost is assumed to be prohibitive.

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Index

Acemoglu, D., 135, 136n7, 138n11, 152n41, 152n42 Actors, 101 Ad valorem tax, 85, 86 Adleman, L., 249 Agency theory, 75 Agrawal, P., 88n12 Aguirre, E., 46n18 Akerlof, G., 54 Alberts, W., 187n13 Alchian, A.A., 15n2, 16n3, 16, 17, 18n7, 22n15, 24n18, 41n16, 41, 50n1, 70n7, 76, 122n16, 125, 185n8, 248 All or nothing demand, 164 Allen, D.W., 8n7, 10n8, 15n2, 27, 34n2, 40n15, 41n16, 41, 46n18, 54, 67n3, 77n17, 77, 85n5, 89n13, 96n26, 100, 101, 104, 108n41, 131n25, 140n15, 147n32, 148n35, 148, 150, 152n41, 154n45, 155n46, 168n8, 185n10, 186n11, 191n20, 193, 207n4, 209n6, 212, 214n11, 215n12, 222 Allen, G.C., 112n4 Allen, W., 15n2, 16n3, 18n7, 185n8 Alston, E., 5n2, 139n13, 142n22 Alston, L., 181n1, 189n16 Anderson, C.L., 191n21 Anderson, T., 39n11, 190n17, 198n31, 207n2, 208 Andolfatto, D., 27 Aoki, M., 140n16, 143n23 Arrunada, B., 140n18, 153n43 Artisan production, 155, 219 Asset specificity, 75 Attributes, 21–22, 53

variable and alterable, 53, 65 Axelrod, R., 106, 207n2 Baker, 105n37 Baker, G., 107 Baland, J., 135n4 Barker, T., 186n11 Barzel, Y., 22n15, 24n18, 41n16, 50n1, 52n3, 56n6, 61n8, 77n17, 77, 126, 148n35, 151n39, 154n45, 155n46, 155n47, 163n3, 209n6, 221n2, 223n5, 225n8, 234n4, 243n1, 251n8, 258 Bates, R., 151n39 Bean, R., 223n6 Becker, G., 22n15, 45, 145n28, 155n46 Behrer, A., 4n1 Berle, A., 127n22 Bertrand, E., 10 Besley, T., 28n24, 103n35, 103, 162n2 Bhattacharyya, S., 88n12 Bilateral Monopoly, 8n7 Bitcoin, 247–250 Blackstone, W., 19n9, 20n9 Blood donation, 235–237 Boettke, P., 137n10 Bogart, D., 140n15, 186n11 Borchers, A., 100 Braido, L., 87n9 Brinig, M., 47n19, 148n35 British Navy, 67, 107 Buckley, F., 47n19 Burchardi, K., 103 Calabresi, G., 4n1 Calvert, R., 140n16

273

Index

274 Camara, B., 85n5, 101n33 Canada, 44, 168, 197n29, 216, 252 Capture, 56, 73 From specialization, 61 Through exchange, 83 Carlos, A., 188n15 Casari, M., 183n5 Caveat emptor exchange, 79, 111, 123, 127, 256 Charity, 236 Cheung, S.N.S., 15n2, 17, 36n7, 41n16, 41, 51, 76n16, 84–88, 88n10, 122n16, 123, 124, 145n28, 171n9, 178 Chisholm, D., 101 Coase, R., 4n1, 6n4, 6n5, 7, 12n10, 14, 33n1, 35, 41, 50, 64, 68–70, 122–125, 184n6, 250 Coase Theorem, 5–10, 34n3, 36n7, 36, 74n13, 82n2, 82, 88n10, 226, 235, 252 defined, 9 and no fault divorce, 45 related to transaction costs, 41 and risk neutrality, 82n2 testing, 10 Cohen, L., 48, 148n35, 149n38 Collective action, 196–197 Command economies, 240n13 Commission Military, 105 Naval, 27 Paid by, 128, 129, 197, 241, 259 Common law, 6, 89n13, 105, 153, 197, 202 Common property, 27, 112–115, 182, 183, 187, 188, 194n25, 253 Mitigation of, 118–121 Communist manifesto, 220 Condominiums, 233 Congost, R., 73n12, 137n10 Constrained efficient, 71–73, 89, 140, 150 Contract law, 154 Cooter, R., 34n3 Costa-Font, J., 235n5 Courts, 105, 202–203 Coverture, 148, 222 Crawford, R., 76, 122n16 Criminal law, 154–156 Custom combining, 131–133 Dahlman, C., 183n5, 183 Dam, K., 192 Dawes Acts, 215

De Soto, H., 4n1, 103 Deacon, R., 174n12 Demsetz, H., 17n4, 17, 33n1, 33, 50n1, 122n16, 125, 187–190, 190n18, 198, 247n6 Diffie, W., 249 Dissipation, 121, 165, 168, 172 Minimization of, 178–180, 210 As transaction cost, 58 Distribution of property rights, 14, 29–31 Divided ownership, see Divided property rights Divided property rights, 22–24, 113n6 Dueling, 146–147, 149–150 Economic property rights, defined, 15 and institutions, 135–138 of married couples, 146 relation to legal and natural rights, 19–21 relation to wealth, 34–39 strength of, 16 theory of, 66–70 types of, 16 Edlund, L., 147n33 Eggertsson, T., 5n2, 71n8 Ellickson, R., 17 Empresario system, 212 Engels, F., 220 Engerman, S., 228n13, 228 Equity capital, 128–131 Espinoza, C., 102 Eswaran, M., 88n12, 108n41 Exchange, 81 Externality, 8 Factory colonies, 221–222 Fink, A., 137n10 Firm vs. market dichotomy, 121–124 Theories of, 125–126 First Possession, 39 by capture, 55–58 Fitton, R., 221 Fletcher, 155n46 Fogel, R., 209n5, 209, 210n7, 228n13, 228 Foss, K., 77n17, 77n18 Foss, N., 77n17, 77n18 Franchise contract, 186 Friedman, D., 15n1, 20n10, 106n38 Friedman, M., 7

Index Geddes, R., 148n37, 222n4, 222 George, H., 85n6 Ghatak, M., 28n24, 103n35, 103 Gil, R., 102 Gisser, M., 200 Gleaning, 156n51, 221 Glennie, P., 104n36, 104 Gold rush California, 38, 191n21, 190–192 Klondike, 101, 191n20 Goldberg, V., 41n16, 122n16 Gordon, H.S., 182, 183 Gorlizki, Y., 17 Government, allocation by, 237–242 Grabowski, H., 236n6 Grapes, 101n33 Greif, A., 136n6, 140n14, 140n16, 143, 144n27, 144, 151n39, 157 Grossman, S., 77n17, 125, 126 Guarantee capital, 128–131, 154 Habib, M., 251n8 Hall, C.D., 117n11 Hart, O., 77n17, 77, 125, 126 Hayek, F., 60, 61, 70n6, 217 Hellman, M., 249 Hicks, J., 33 Hill, P.J., 39n11, 190n17, 198n31, 207n4, 208 Hodgson, G., 4n1 Holmstrom, B., 88n12, 125, 126 Homesteading, 168, 170, 207–215 Hornbeck, R., 39n11, 190n17 Human rights, see Natural property rights Immigration, 102 Imperfect property rights, 27–29 Incomplete property rights, 25–27 Indentured servitude, 105, 223, 230, 231 Industrial revolution, 104, 140n15, 155, 221, 222 Information costs, 50–63 Necessary for transaction costs, 51 Innovations, 105, 131, 155n48, 155 Property rights to, 246–247 Institutions Defined, 137 Endogenous, 139–141 Related to organizations, 138–139 Related to property rights, 135–138 As rules, 141–143 As rules ... plus, 143–144 Insurance, 115–117

275 Jensen, M., 41n16, 122n16 Jewish law, 230n17 Johnsen, D.B., 196, 251n8 Johnson, R., 200n34 Johnson, S., 135 Jones, E., 228n12 Kalt, J., 172n10 Kessel, R., 16, 235, 236 Kitch, E., 7n6 Kiyotaki, N., 248n7 Klein, B., 76, 107, 122n16, 125, 203n36 Knight, F., 53, 77, 182, 187 Korn, E., 147n33 Kotwal, A., 88n12, 108n41 La Porta, R., 135 Lafontaine, F., 88n12, 102 Lancaster, K., 22n15 Land grants, 206–209 Landa, J., 17 Landes, D., 104 Landes, W., 203n36 Leffler, K., 63n10, 101, 107 Legal ownership, 4, 6 contrast to economic owner, 28 Legal property rights, 18, 103–106 Defined, 18 Emergence, 150–152 Leonard, B., 168n8, 198n31, 207n4, 214n11, 215n12 Lewis, F., 188n15 Libecap, G., 189n16, 198n31 Locke, A., 5n2 Locke, J., 15n2, 19n8 Lueck, D., 41, 54, 85n5, 89n13, 96n26, 100, 101n33, 108n41, 112n5, 131n25, 148n37, 183n3, 183, 187n14, 194n25, 222n4, 251n9, 252, 253 Macneil, I., 106n39 Manning, R., 236n6 Manumission, 225, 230n19 Market failure, 185, 232 market transaction, 123n20, 123, 125, 235 with respect to Coase, 50–51, 122 and transaction costs, 33 Marriage, 144–149 Marx, K., 220 Masten, S., 5n2 Master-servant relations, 105, 220, 222, 223n7, 223

Index

276 Matchmaker, 61 Matouschek, N., 148n35 McChesney, F., 207n2 McCloskey, D., 7n6 McManus, J., 41n16, 188n15, 197n29 Means, G., 127n22 Measurement, 55–58 Meckling, W., 41n16, 122n16 Medema, S., 6n3, 7n6 Mehrdad, V., 5n2 Menard, C., 102, 135n1 Merrill, T., 153 Methodological individualism, 66, 238 Mijiya, A., 5n1 Milgrom, P., 88n12, 125, 126 Miller, K., 198n31 Mittal, S., 140n16 Mokyr, J., 144n27, 155n48 Money, 247–250 Monopoly, 243–245 Moore, J., 77n17, 125, 126, 248n7 Moral rights, see Natural property rights Murrell, 141n19

Predatory pricing, 244 Price controls, 170–178 Price estimates, 250–251 Priest, G., 203n36 Private orderings, 12, 137, 143 Private vs. public ownership, 184 property law, 153 Property Rights, neoclassical approach to, 4 complete, definition, 25 divided, 22–24 economic, 14–32 efficient, 70–73 forming, 181–184 hypothesis, 67 incomplete, 25–27 literature, 75–77 optimal level, 42 relation to ownership, 5 scope of, 25 strength of, 16, 28 undivided, definition, 23 Public Domain, 56 capture within, 4, 161

Narrow corridor, 136n7, 138n11 National football league, 43 Natural property rights, 18 defined, 18 Neoclassical problem, 10–12 Nichols, 207n2 Niehans, J., 33, 51 No fault divorce, 44–48 No till agriculture, 100 Non free labor, 219–221 North, D., 22n15, 50n1, 135n3, 135, 136n6, 139n13, 142–144, 152n42 North Sea, rights to, 192–193 Nunn, N., 135n2, 135

racing, 168–170 railroads, 207–215 Ransom, 35 Rasul, I., 148n35 Rent contracts, 85, 89–92, 100–102 Rent seeking, 5, 75, 76, 149 Residual claimant, 17 Residual(s), 17, 24 Claimants, 16, 17, 24, 84, 97, 98, 99n30, 111, 112, 116, 122, 126–128, 148, 152, 197, 237, 241 Rhinoceros, 195–196 Richardson, G., 140n15 Riker, W., 142n21 Rivest, R., 249 Roads, private vs. public, 185–187, 205 Robinson, J., 135, 138n11, 152n41 Rockoff, H., 172n10 Rose, C., 198n30 Rowling, J.K., 21 Rucker, R., 101

Open access, 17, 112n5, 139n13, 183n3, 183, 191, 193, 251 Ostrom, E., 5n2, 142n22, 142, 183n4 Ownership, complicated assets, 111–113 Pashigan, P., 52n4 Perfect property rights, definition, 28 Peters, E., 46n18 Pigouvian tradition, 8 Plott, C., 142n21 Podesta, 152 Police, 154–156 Posner, R., 24n18

Sales, 52–53 Santos, R., 85n5, 101n33 Sass, T., 234n4 Savage, C., 186n11 Scalping, 167

Index Searle, J., 144n27 Service flows, 58–60 Shamir, A., 249 Shapiro, C., 107 Share contracts, 83–88, 98–102, 124, 130, 143 Shared ownership, 29 Shirking, 5, 67, 75, 83, 98, 112, 240n13 Shirley, M., 135n1, 135n5 Signaling, 75, 76n15 Silberberg, E., 93n21 Slavery, 223–231 Smith, A., 4n1, 70n6, 85, 88n11 Smith, H., 153, 194n26 Social norms, 137 Sole ownership Costs of, 108–109 Sonstelie, J., 174n12 Sorting, 55–58 Spontaneous orders, 70, 140 Standardization, 22, 155–156 Stephany, A., 61n8 Stigler, G., 7, 9 Stiglitz, J., 76n16 Suen, W., 93n21, 168, 233n1 Theft, 11n9, 16, 29, 40, 52, 53, 75, 105, 154–156, 193–197, 220–223, 229–231, 245–246 Thomas, R., 223n6 Thrift, N., 104n36, 104 Timber sales, 101 Time, 104 Transaction costs, 33–49 as deadweight loss, 41 defined, 40

277 as a friction, 33 necessary for theory of ownership, 9 as related to the distribution of property rights, 64–66 Turnpike trust, 186 Umbeck, J., 38, 190n19, 190, 191n21, 193 Undivided property right, definition, 23 Utley, 207n2 Voigt, 142 Voting, 233–235 Wadsworth, A., 221 Wage contracts, 84, 100–102, 105, 108n41, 118–119, 129, 154 Waiting, 161–165 Wallis, J., 135n3, 136n6, 140n14, 142 Walrasian auctioneer, 10 Wantchekon, L., 135n2 Water, 197–200 Wealth, maximal function, 38–39 Webb, B., 186n12 Webb, S., 186n12 Weingast, B., 135n3, 136n6, 140n16 Werner, M., 200n34 Wickelgren, A., 148n35 Wildlife, 251–253 Williamson, O., 5n2, 54, 75, 122n16, 221n3 Wolfers, J., 46n18 Woodward, S., 41n16 Yonai, D., 17 Yu, B., 247n6 Zerbe, R., 191n21

Other books in the series (continued from page iii) Peter Cowhey and Mathew McCubbins, eds., Structure and Policy in Japan and the United States: An Institutionalist Approach Gary W. Cox, The Efficient Secret: The Cabinet and the Development of Political Parties in Victorian England Gary W. Cox, Making Votes Count: Strategic Coordination in the World’s Electoral System Gary W. Cox, Marketing Sovereign Promises: Monopoly Brokerage and the Growth of the English State Gary W. Cox and Jonathan N. Katz, Elbridge Gerry’s Salamander: The Electoral Consequences of the Reapportionment Revolution Adam Dean, Opening Up by Cracking Down: Labor Repression and Trade Liberalization in Democratic Developing Countries Tine De Moore, The Dilemma of the Commoners: Understanding the Use of Common-Pool Resources in Long-Term Perspective Adam Dean, From Conflict to Coalition: Profit-Sharing Institutions and the Political Economy of Trade Mark Dincecco, Political Transformations and Public Finances: Europe, 1650–1913 Mark Dincecco and Massimiliano Gaetano Onorato, From Warfare to Wealth: The Military Origins of Urban Prosperity in Europe Raymond M. Duch and Randolph T. Stevenson, The Economic Vote: How Political and Economic Institutions Condition Election Results Jean Ensminger, Making a Market: The Institutional Transformation of an African Society David Epstein and Sharyn O’Halloran, Delegating Powers: A Transaction Cost Politics Approach to Policy Making under Separate Powers Kathryn Firmin-Sellers, The Transformation of Property Rights in the Gold Coast: An Empirical Study Applying Rational Choice Theory Clark C. Gibson, Politicians and Poachers: The Political Economy of Wildlife Policy in Africa Daniel W. Gingerich, Political Institutions and Party-Directed Corruption in South America Avner Greif, Institutions and the Path to the Modern Economy: Lessons from Medieval Trade Jeffrey D. Grynaviski, Partisan Bonds: Political Reputations and Legislative Accountability Stephen Haber, Armando Razo, and Noel Maurer, The Politics of Property Rights: Political Instability, Credible Commitments, and Economic Growth in Mexico, 1876–1929 Ron Harris, Industrializing English Law: Entrepreneurship and Business Organization, 1720–1844 Anna L. Harvey, Votes Without Leverage: Women in American Electoral Politics, 1920–1970

Seth J. Hill, Frustrated Majorities: How Issue Intensity Enables Smaller Groups of Voters to Get What They Want Shigeo Hirano and James M. Snyder, Jr., Primary Elections in the United States Murray Horn, The Political Economy of Public Administration: Institutional Choice in the Public Sector John D. Huber, Rationalizing Parliament: Legislative Institutions and Party Politics in France Jack Knight, Institutions and Social Conflict Sean Ingham, Rule of Multiple Majorities: A New Theory of Popular Control John E. Jackson, Jacek Klich, Krystyna Poznanska, The Political Economy of Poland’s Transition: New Firms and Reform Governments Jack Knight, Institutions and Social Conflict Michael Laver and Kenneth Shepsle, eds., Cabinet Ministers and Parliamentary Government Michael Laver and Kenneth Shepsle, eds., Making and Breaking Governments: Cabinets and Legislatures in Parliamentary Democracies Michael Laver and Kenneth Shepsle, eds., Cabinet Ministers and Parliamentary Government Margaret Levi, Consent, Dissent, and Patriotism Brian Levy and Pablo T. Spiller, eds., Regulations, Institutions, and Commitment: Comparative Studies of Telecommunications Leif Lewin, Ideology and Strategy: A Century of Swedish Politics (English Edition) Gary Libecap, Contracting for Property Rights John Londregan, Legislative Institutions and Ideology in Chile Arthur Lupia and Mathew D. McCubbins, The Democratic Dilemma: Can Citizens Learn What They Need to Know? C. Mantzavinos, Individuals, Institutions, and Markets Mathew D. McCubbins and Terry Sullivan, eds., Congress: Structure and Policy Anne Meng, Constraining Dictatorship: From Personalized Rule to Institutionalized Regimes Gary J. Miller, Above Politics: Bureaucratic Discretion and Credible Commitment Gary J. Miller, Managerial Dilemmas: The Political Economy of Hierarchy Ilia Murtazashvili, The Political Economy of the American Frontier Monika Nalepa, After Authoritarianism: Transitional Justice and Democratic Stability Douglass C. North, Institutions, Institutional Change, and Economic Performance Elinor Ostrom, Governing the Commons: The Evolution of Institutions for Collective Action Sonal S. Pandya, Trading Spaces: Foreign Direct Investment Regulation, 1970–2000 John W. Patty and Elizabeth Maggie Penn, Social Choice and Legitimacy Daniel N. Posner, Institutions and Ethnic Politics in Africa J. Mark Ramseyer, Odd Markets in Japanese History: Law and Economic Growth J. Mark Ramseyer and Frances Rosenbluth, The Politics of Oligarchy: Institutional Choice in Imperial Japan Stephanie J. Rickard Spending to Win: Political Institutions, Economic Geography, and Government Subsidies

Jean-Laurent Rosenthal, The Fruits of Revolution: Property Rights, Litigation, and French Agriculture, 1700–1860 Michael L. Ross, Timber Booms and Institutional Breakdown in Southeast Asia Meredith Rolfe, Voter Turnout: A Social Theory of Political Participation Shanker Satyanath, Globalization, Politics, and Financial Turmoil: Asia’s Banking Crisis Alberto Simpser, Why Governments and Parties Manipulate Elections: Theory, Practice, and Implications Norman Schofield, Architects of Political Change: Constitutional Quandaries and Social Choice Theory Norman Schofield and Itai Sened, Multiparty Democracy: Elections and Legislative Politics Alastair Smith, Election Timing Pablo T. Spiller and Mariano Tommasi, The Institutional Foundations of Public Policy in Argentina: A Transactions Cost Approach David Stasavage, Public Debt and the Birth of the Democratic State: France and Great Britain, 1688–1789 Charles Stewart III, Budget Reform Politics: The Design of the Appropriations Process in the House of Representatives, 1865–1921 George Tsebelis and Jeannette Money, Bicameralism Georg Vanberg, The Politics of Constitutional Review in Germany Nicolas van de Walle, African Economies and the Politics of Permanent Crisis, 1979–1999 Stefanie Walter, Financial Crises and the Politics of Macroeconomic Adjustments John Waterbury, Exposed to Innumerable Delusions: Public Enterprise and State Power in Egypt, India, Mexico, and Turkey David L. Weimer, ed., The Political Economy of Property Rights Institutional Change and Credibility in the Reform of Centrally Planned Economies