Property Rights, Ownership,and Economic Efficiency

Prof. BrysonManagerial Economics

Learning Objectives

Define Ownership and Property Rights Explain Externalities in

� production� consumption

Understand How Externalities Prevent Efficient Exchange

Understand The Coase Theorem Other Solution to Externalities

Ownership

Ownership and secure property rights are the most effective institutions for providing incentives to create, maintain, and improve assets. Lack of these in Socialist East Europe dulled incentives to maintain assets, to innovate and take risks, and to create new wealth.”

Ownership

Owning an Asset is to have the residual rights of control. What is “residual” about rights to control?

The owner may make decisions concerning the property’s use where it is not explicitly controlled by law or assigned to another by contract), and ?

Ownership

The owner of a firm, as the residual claimant is entitled to receive any net income that the firm produces.

This is the residual return--the amount left over after everyone else has been paid.

Ownership

Incentives� Eastern Europe

Efficiency Economic agents

Dublin

Oslo

Stockholm

London

Paris

Helsinki

Berlin

Budapest

Praha

Warsaw

Reykjavik

Bucharest

SofiaSkopje

Train

Belgrade

Sarajevo

Zagreb

Vienna

Bern Ljubljana

Athens

Brussels

Amsterdam

Madrid

Lisbon

Rome

Bratislava

Copenhagen

Luxembourg

Externalities

External effects arise from the costs or benefits imposed involuntarily on another party or other parties not directly involved in a given transaction. Such costs or benefits are not regulated by any system of price.� positive externality� negative externality

Costs: A Perspective

What are “private” costs?� The costs borne by the initiator of some activity� Example, the private, production cost of

producing steel What are social costs?� Total costs are borne by all members of society

� Example, when steel is produced in Utah Valley, private users of air pay a high cost in terms of the fine particles inhaled into their system.

Market Failure, Externalities

Externalities preclude efficient production outcomes � prices relayed to producers and consumers

lead them to the wrong quantity, which quantity will also be sold at the wrong price.

With a negative externality, too large a quantity is produced.

With a positive externality too small a quantity is produced.

Negative Production Externality

The market supply curve is S1, the curve S2 incorporatesthe costs of production borne by society. The marketoutcome is point A, the efficient outcome is point B.

TOO MUCH IS PRODUCED

S2

S1

D

These are private costs only.

These costs include social costs

Q

P

QpQs

Ps

PpA

B

Positive Consumption Externality

D1 is the market demand, D2 isthe demand accounting for theexternal benefit

TO

O L

ITT

LE O

UT

PU

T

D1

D2

Ps

Pp

QsQp

S

Public and Private Goods

Public Good� nonrivalous consumption� nonexcludability

The Market For Fireworks The Market For National Defense

Market Failure

Free Rider Problem

Government and Market Failure.

What kinds of policies should the government establish?

The Tragedy of The Commons

The lack of clearly defined property rights and ownership can lead to an inefficient allocation of resources.� greenhouse effect (global warming)� over-fishing

Ill-Defined Property Rights and the Commons

• If many people have the right to use a single shared resource, then they have an incentive to overuse the resource.

• If many people share the obligation to provide some resource, then they have an incentive to undersupply that resource.

Ill-Defined Property Rights and the Commons

• When the residual returns to an asset are widely shared (not collected by a “boss”), no one person has a sufficient interest to bear the costs of maintaining and increasing its value.

• In such cases, concentrating the ownership rights can lead to increased efficiency” (Millgrom and Roberts p. 294).

Example of Ocean Fisheries

• To maintain the stock of fish, a large enough portion must survive for breeding. If large numbers hold commercial fishing rights, there is a danger of overfishing, (too many taken for recovery).

• An appropriate assignment of ownership or property rights might alleviate this problem:

Example of Ocean Fisheries

• An appropriate assignment of ownership or property rights might alleviate this problem:

– Group ownership. A fishery association gains exclusive right of control

• rights to determine who may fish

• for how large a total catch, and

• rules of fishing (hours and seasons when allowed, mesh size of nets, etc.)

Example of Ocean Fisheries, cont.

Individuals are assigned rights to participate in various ways. They could share the total catch equally, or be assigned a quota. The association has a collective incentive to safeguard the fish population.

Example of Ocean Fisheries, cont.

Problems: it may be costly to keep out interlopers, there may be severe moral hazard problems among the individual members of the association (cheating on the quota), differing ideas about how many can safely be taken, etc.

• Single Ownership. This approach works well with private ownership (e.g., private automobiles). Same incentives to preserve the resource.

• Major problem: deciding who will be the lucky owner.

Example of Ocean Fisheries, cont.

• Rotating property rights is terribly inefficient, (permits over-harvesting since current fisher doesn’t gain from preserving a harvest for next year.)

• Rights could be auctioned and the highest bidder could compensate losers by distributing proceeds of the auction among them. But it’s hard to determine just compensation.

Example of Ocean Fisheries, cont.

Incentives and Property Rights

Without proper incentives, no one person is motivated to use the proper amount of a scarce resource.

The Coase Theorem

If there are no legal, strategic, or informational barriers to bargaining, and if property rights are clearly defined,…

Ronald Coase Nobel Prize in Economics, 1993

The Coase Theorem

… then people can always negotiate to an efficient outcome.

Note the minimal role this implies for government.

Problems With The Coase Theorem

Transaction Costs May Exist � bargaining may be expensive

Property Rights May Not Be Clearly Assigned

Problems With The Coase Theorem

• Sometimes there are legal impediments to what society considers immoral. This can effect the achievement of an economically efficient solution.

Problems With The Coase Theorem

• Sometimes there are costs of determining, writing, and enforcing an agreement in a world of bounded rationality, imperfect communication, private information, observation and verification difficulties, and opportunism.

Property Rights Must Be Secure and Transferable

• If property rights are not secure, there will be no incentive to invest in or improve assets.

Farm for sale near Oshkosh

Property Rights Must Be Secure and Transferable

• If property rights are not transferable (subject to purchase and sale), the Coase theorem cannot work. That is, they will not tend to be acquired by those who can use them best.

Farm for sale near Oshkosh

Result of the Difficulties?

• Many arrangements are not made through private negotiation, but through governmental fiat.

• Property rights are simply assigned, and the initial assignment, made by the government, is very important about who will bear the costs of transfer.

• Assignments are made, for example, through patent, trademark and copyright laws.

Example of Bargaining

Steel in Utah Valley,In another age.Related by Howard Barnes

Example of The Coase Theorem:Assigning Property Rights for a Railroad through Farm Country

The Railroad and The Farmer� how many trains to run (before fires start)� how many acres to plant (and how close to

tracks) What is the socially optimal number of trains to run

and acres of crops to plant?

Example of The Coase Theorem:Assigning Property Rights for a Railroad through Farm Country

The socially optimal number of trains to run or acres of crops to plant depends on whether the railroads or the farms are assigned property rights for the land on which the railroad is placed.

Analysis requires knowledge of the specific law, of economics, and an understanding of incentives.

Other Solutions to Externalities

Cooperation and Group Ownership� bargaining costs

Regulatory Response� does someone really know best?

Taxes and Subsidies� taxes, at least, are politically unpopular

Complex Ownership The Firm as the Primary Example

• By law, stockholders or shareholders own the corporation, but rights are quite limited.

Complex Ownership The Firm as the Primary Example

• They can vote to:

• change the corporate charter,

• elect the directors and remove them by majority vote, and

• vote on substantial changes, such as mergers.

•That is all!

Complex Ownership The Firm as the Primary Example

They cannot decide on

• day by day business policy,

• the dividends they receive,

• investments or acquisitions, nor

• who will be the manager or

• what the salary will be.

The Board of Directors in Control?

• The board of directors has the power to

– set dividends, – to hire, fire, and set compensation of the

senior executives,– to decide to enter new lines of business, – to reject merger offers or approve and

submit them to shareholders, etc.

The Board of Directors in Control?

• In the US, the board of directors’ authority is buttressed by the “business judgment rule,” so that the courts will not try to second-guess the directors’ business decisions. But directors are not free to appropriate the profits for their own use.

• BUT, directors must generally rely on the officers of the firm for information. By controlling information and by setting the agenda, the senior executives will generally have effective control.

The Duty of the Corporate Agency

• Free-market economists, private and institutional investors, argue– maximizing the value of the

firm enhances economic efficiency. If they don’t, they are arrogantly, opportunistically acting like the principal, not the agent.

The Duty of the Corporate Agency

• On the other hand, some academics and activists argue– the pursuit of profits is

socially inappropriate or immoral.

– Society seems to be the principal in their beliefs.