Economics 103Lecture # 19

Transaction Cost Economics

Continued

So transaction costs are the costs of establishing and maintaining economic property rights.

So what?

This leads to our seventh and final economic principle:

If TC = 0 organization doesn’t matter (the Coase theorem).

If TC > 0, then people organize to minimize these costs.

In order to understand Property rights, then, we must understand transaction costs.

Let’s use this notion of transaction costs to understand some simple property right distinctions.

Private Property

-you have the economic right to exclude, transfer and enjoy an asset.- let’s suppose you have these rights at zero transaction costs.

Suppose you own a boat, and there is a lake with fish in it.

You can always catch 4 fish on shore, but you can catch more fish with the boat.

You have to decide how many fishermen should be in the boat.

Suppose the marginal product of labor on the boat looks like:

As we’ve seen before, you hire L* fishermen, and this maximizes the value of the boat (equal to the shaded area).

Private property looks pretty good.

Common Property

-a group has the right to exclude, transfer, and enjoy the boat.- the group shares in the catch.

Now the groups would want to maximize the AVERAGE PRODUCT.

This would mean L’ fishermen.

-note the DWL, and the lower value of the boat.

Open Access

- here no one has the right to exclude others from using the boat.

- now people join the boat as long as the average catch is greater than four fish.

-the value of the boat is zero.

- there is a huge DWL.

-Open access looks pretty bad as a property rule.

Yet when we look around we see the different types of property rules used.

In the family, think of all the things that are common property.

Why within a family would we choose a property rule that has such clear inefficiencies?

The answer is that the transaction costs, the costs of maintaining the PR in each case are much different.

When the cost of keeping trespassers off is low, we tend to have private property.

.

For the open seas, we use a

It is just too costly to police the resource.

So common property is one way a group might establish some PR over a resource.

Homesteading

In the 19th century, both the US and Canadian govt. had a problem.

How do you establish ownership over: Countries had no money for armies

The solution was to create homesteads.

These were farms in the middle of nowhere.

Every district was divided up on a grid.

Every grid was divided up into sections (1 square mile). 36 sections made a township.

Section

Quarter Section

Homesteading was costly, because people “rush” to the land, long before it is viable to farm.

Do you remember this movie:

They did it because having a large number of citizens rush to an area established ownership.

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So depending on the transaction costs, some forms of property rights are better than others.

The Optimal Value of an Asset.

When does a good move from open access/ public domain, to private property.

When the value of the good is greater than the TC of establishing ownership.

According to this graph, any asset worth more than Vc would be privately owned.

So, low valued things like

But what would happen if the TC function was not linear?

Now there is an optimal value of an asset.

Some assets may be so valuable that they cost more to police than they are worth!

According to the graph, you would put them back in the public domain!

That seems unlikely. Two options seem more likely:

1. Try to invent some type of protection technology to lower TC.

Eg.

2. Lower the value of the asset.

A problem with Rhinos, is that poachers kill them for the horn.

The horn is so valuable, it is too costly to protect it. Solution:

This may provide an explanation of some built in obsolescence.

What does a terminator gene look like?

Why would Monsanto spend over 1Billion for a gene that lowers the value of a seed?

So what is the general lesson?

Property rights matter.

We choose those property rights that maximize wealth

net of the transaction costs associated with those property rights.