1.3 — Property Rights & Transaction Costs

# 1.3 — Property Rights & Transaction Costs
## ECON 410 • Public Economics • Spring 2022
### Ryan Safner Assistant Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/publicS22">ryansafner/publicS22</a> <a href="https://publicS22.classes.ryansafner.com"> publicS22.classes.ryansafner.com</a>

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# Last Class...(Maybe)

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![:scale 70%](https://www.dropbox.com/s/13nf8zhqzs45zii/internalizeexternalitiesmeme.jpg?raw=1)
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# Takeaways from Coase I

(1910-2013)

Economics Nobel 1991]

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- Externalities can be framed as a problem of .hi-purple[property rights]

- Exchange is really about property rights over goods and services, (not just the goods themselves)

- Property rights can internalize externalities
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# Takeaways from Coase II

(1910-2013)

Economics Nobel 1991]

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.right-column[
- .hi["Coase Theorem"]: if transaction costs are low, parties will bargain to the efficient outcome regardless of who has property rights

- Coase: transaction costs **are** high, so **it matters** how property rights are allocated!

- Look at real world institutions
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# Another Classic Economic Problem

- .hi[Tragedy of the commons]: multiple people have unrestricted access to the same .hi-purple[rivalrous] resource

- .hi-purple[Rivalry]: one use of a resource removes it from other uses

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# Another Classic Economic Problem

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![:scale 100%](https://www.dropbox.com/s/qgnqwqr86wi1nlz/pollutedriver.png?raw=1)
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- Cannot exclude others

- No responsibility over outcome

- Incentive to **overexploit** and **deplete** resource (before others do)

- A negative externality on others
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# Classic Solution: Property Rights

- .hi[Property rights]: socially agreed upon rules that determine how resources are used

- Primary right is the .hi-purple[right to exclude others] from using a rivalrous resource
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# Property Rights

Sir William Blackstone

(1723-1780)
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> “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,” (Book II, Chapter 1).

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# Property Rights

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> “.hi[Property] is a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” (Cooter and Ulen, p.73)

- This bundle contains a lot of rights, to:

> possess, use, develop, improve, transform, consume, deplete, destroy, sell, donate, bequeath, transfer, mortgage, lease, loan, or exclude others

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# Property Rights

- Three important legal points:

1. These rights are .hi[impersonal] — they attach to property, not persons

2. Owner is .hi[at liberty] to exercise rights over her property (law neither forbids nor obliges her to)

3. Others are .hi[forbidden to interfere] with owner’s exercise of her rights

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# Property Rights Internalize Externalities

- Links ownership and responsibility

- Causing arm to others' property `\(\implies\)` liability for damages

- Externalities as (unenforced) property rights
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.pull-right[
.center[
*"Good fences make good neighbors"*
![](https://www.dropbox.com/s/4e58agciph8fbww/goodfences.jpg?raw=1)
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# The Benefits & Costs of Property Rights

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# Why Do We Need Property Law?

- A solution to the tragedy of the commons

- Imagine two neighboring farmers
  - game theoretic interaction
  - each farmer can either .hi-purple[Farm] or .hi-purple[Steal]
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# Why Do We Need Property Law?

- Suppose:
  - crops are valued at 15
  - planting & watering costs 5
  - stealing costs 3

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# Why Do We Need Property Law?

- Suppose:
  - crops are valued at 15
  - planting & watering costs 5
  - stealing costs 3

- With no legal system, the game looks like:

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# Why Do We Need Property Law?

- .hi-purple[Nash Equilibrium]: (.red[Steal], .blue[Steal])

- .hi-purple[Socially optimal equilibrium]: (.red[Farm], .blue[Farm])

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# Property Is a Necessary Part of the Solution

David Hume

1711-1776
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> “But although men can maintain a small uncultivated society without government, they can’t possibly maintain a society of any kind without justice, i.e. without obeying the three fundamental laws concerning the stability of ownership, its transfer by consent, and the keeping of promises.”

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# Property Is a Necessary Part of the Solution

- They recognize that establishing rules of property and punishing theft achieves the social optimum
  - Setting up a property law system (and someone to enforce it) has costs `\(c\)`
  - The punishment to theft is `\(P\)`

- If `\(10-c>12-P\)`, then (.red[Farm],.blue[Farm]) becomes an equilibrium

- What are the costs of property rights, `\(c\)`?
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# Property Rights Internalize Externalities

Harold Demsetz

1930-2019
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.smallest[
> “.hi[A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities]. Every cost and benefit associated with social interdependencies is a potential externality. One condition is necessary to make costs and benefits [become] externalities. The cost of a transaction in the rights between the parties (internalization) must exceed the gains from internalization. In general, transacting cost can be large relative to gains because of ‘natural’ difficulties in trading or they can be large because of legal reasons,” (p.348).

> “.hi[Property rights develop to internalize externalities when the gains from internalization become larger than the costs of externalization],” (p.350).

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.source[Demsetz, Harold, 1967, "Towards a Theory of Property Rights," *American Economic Review* 57(2): 347-359]

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# But Property Rights Are Costly

- Externalities can be solved by defining property rights and permitting exchanges

- There are always transaction costs to exchange

- If transaction costs are low, efficient to create & exchange property rights

- .hi[If transaction costs are high, *inefficient* to create property rights!]
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# It's Just a Cost-Benefit Calculation

- Essentially, does .hi-purple[MB > MC] of internalizing the externality?
  - **If yes**: create property rights, internalize externalities
  - **If no**: leave as commons, incur externalities

- Exogenous shocks — opening new markets, technological change, etc — can change this equilibrium!

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# Demsetz’ Example: Efficient to Keep as a Commons

Harold Demsetz

1930-2019
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> “A close relationship existed, both historically and geographically, between the development of private rights in land and the development of the commercial fur trade.

> “Because of the lack of control over hunting by others, it is in no person’s interest to invest in increasing or maintaining the stock of game.  Overly intensive hunting takes place.

> “Before the fur trade became established, hunting was carried on primarily for purposes of food and the relatively few furs that were required for the hunter’s family.  The externality was clearly present...but these external effects were of such small significance that it did not pay for anyone to take them into account.” (p.351).

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.source[Demsetz, Harold, 1967, "Towards a Theory of Property Rights," *American Economic Review* 57(2): 347-359]

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# ...Until an Exogenous Change

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# ...Until an Exogenous Change

Harold Demsetz

1930-2019
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> “[T]he advent of the fur trade had two immediate consequences. First, the value of furs to the Indians was increased considerably. Second, and as a result, the scale of hunting activity rose sharply. Both consequences must have increased considerably the importance of the externalities associated with free hunting. The property right system began to change.”

> “[Algonkians and Iroquois] divide themselves into several bands in order to hunt more efficiently. It was their custom...to appropriate pieces of land about two leagues square for each group to hunt exclusively. Ownership of beaver houses, however, had already become established, and when discovered, they were marked. A starving Indian could kill and eat another's beaver if he left the fur and the tail.”

> “The principle of the Indians is to mark off the hunting ground selected by them Dy blazing the trees with their crests so that they may never encroach on each other...By the middle of the century these allotted territories were relatively stabilized,” (p.352).

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.source[Demsetz, Harold, 1967, "Towards a Theory of Property Rights," *American Economic Review* 57(2): 347-359]

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# Tech. Change Can *Reduce Costs* of Property Rights

.center[
![:scale 60%](https://www.dropbox.com/s/dw0vevynralcmxm/barbedwirestory.png?raw=1)
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.source[Source: [TED Ideas](https://ideas.ted.com/why-barbed-wire-yes-barbed-wire-was-as-transformative-as-the-telephone/)]

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# Tech. Change Can *Raise the Benefits* of Property Rights

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The electromagnetic spectrum allocated by the Federal Communications Commission to private parties ([high res](https://www.ntia.doc.gov/files/ntia/publications/2003-allochrt.pdf))
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# Tech. Change Can *Raise the Benefits* of Property Rights

.center[
![:scale 100%](../images/spectrumauctionsarticle.png)
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.source[Source: [Priceonomics](https://priceonomics.com/the-spectrum-auction-how-economists-saved-the-day/)]
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# Summarizing Coase & Demsetz

- **Coase**: if property rights are clearly defined and tradeable, we'll get efficient outcomes
  - Fix externalities by expanding property rights

- **Demsetz**: yes, but this comes at a .hi-purple[cost]!
  - Property rights will expand only when the .hi-purple[benefits outweigh the costs]
  - Either because benefits rise, or costs fall
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# Of Course, Coase Knew About Transaction Costs!

(1910-2013)

Economics Nobel 1991
]

]
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> “If market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast.

> “But...the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law.”

> “In such cases, the courts directly influence economic activity.”

> “Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out.”

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.source[Coase, Ronald H, 1960, “The Problem of Social Cost” *Journal of Law and Economics* 3: 1-44]
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# Transaction Costs & Some Normative Prescriptions

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# Transaction Costs

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- .hi[Transaction costs]: the costs of voluntary exchange (or markets)
  - .hi-purple[Search costs]: cost of finding trading partners
  - .hi-purple[Bargaining costs]: cost of reaching an agreement
  - .hi-purple[Enforcement costs]: **trust** between parties, cost of upholding agreement, dealing with unforeseen contingencies, punishing defection, using police and courts 
]

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# Focus on Bargaining Costs