Transaction Costs And Property Rights Research Paper

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Transaction costs and property rights are related, important, and expansive concepts. Both move beyond technology to introduce law and organization. Both deal with issues of first-order economic importance (as against nuances). Because both have been difficult to operationalize, both have been used expansively and tautologically.

Property rights is the older concept, going back to antiquity. The use of transaction cost reasoning in the 1960s brought new life to the property rights movement. Not only is the economics of property rights basic, enduring, and important in its own right, but it also helped to usher in and remains an important part of the new institutional economics: ‘Modern institutional economics focuses on the institution of property and on the systems of norms governing the acquisition or transfer of property rights’ (Furubotn and Richter 1991, p. 7). Of the various categories of property rights, the right of ownership—which consists of the right to use an asset, the right to appropriate the returns from an asset, and the right to change its form, substance, or location (Furubotn and Richter 1991, p. 6)—is the most important.

The paper begins with a sketch of the antecedents, then some of the leading property rights successes are examined, followed by the limitations and the conclusion.

1. Antecedents

Frank Michelman (1967) traces property rights concepts and thinking from Aristotle through the Christian Fathers, John Locke, David Hume, Jeremy Bentham, and Oliver Wendell Holmes. Despite this early and continuing interest, the economics of property rights ‘has not been discussed analytically until very recently’ (Demsetz 1998, p. 144). The introduction of transaction cost reasoning into the study of property rights in the 1960s is responsible for much of the analytical advance.

2. Modern Property Rights

2.1 Externalities

Work on the economics for property rights flourished in the 1960s. Leading contributors included Ronald Coase (1959, 1960), Armen Alchian (1961, 1965), and Harold Demsetz (1967). Much of this work contested the orthodox interpretation of externalities as ‘market failures’ for which government intervention ‘in the form of taxes, or subsidies, or regulation’ was presumptively warranted. Rather than take property rights assignments as given, Coase moved the analysis back a step to examine the ramifications of reassigning property rights. His treatment brought out ‘the reciprocal nature of the relationship which tends to be ignored by economists who, following Pigou, approach the problem in terms of a difference between private and social producers but fail to make clear that the suppression of the harm which A inflicts on B inevitably inflicts harm on A. The problem is to avoid the more serious harm’ (Coase 1959, p. 24). Assessing the more serious harm entailed introducing transaction costs.

Coase proceeded in a two-part way. Starting with the assumption of zero transaction costs, Coase advanced the (then) revolutionary proposition that ‘the delimitation of rights is an essential prelude to market transactions; but the ultimate result (which maximizes the value of production) is independent of the legal [award of property rights to one party rather than the other]’ (Coase 1959, p. 25). This is because, distributional considerations aside, the parties will bargain to the same efficient result whichever way property rights are awarded.

For Coase, however, this was an expositional device. The real world is one of positive transaction costs, whereupon the assignment of property rights one way or another does matter. Efficiency now turns on the differential transaction costs of assigning property rights one way rather than another. Coase furthermore contested the idea that a ‘benign government’ could be used to correct market failures, it being the case that all feasible forms of organization are flawed (Coase 1964). He also advised that total as well as marginal conditions needed to be included in a comparative assessment: there is a need to ‘compare the total product yielded by alternative social arrangements’ (Coase 1960, p. 42). This comparative approach in which transaction costs are featured reshaped the study of property rights, market failures, and economic organization in the ensuing years, up to and including the present.

2.2 Common Pool Problems

Common pool problems arise in a variety of contexts, of which common grazing land (Hardin 1968), fisheries (Turvey 1964), petroleum extraction (Libecap and Wiggins 1985), and water and air pollution are familiar examples. Whereas the externalities examined by Coase were predominantly of a bilateral kind, the common pool problem poses the need to coordinate many actors. Additional problems arise because (a) different actors are differently situated, (b) the relevant information is dispersed and costly to verify, (c) strategizing and politicking often arise, and consent is needed to, (d) agree on an overarching plan, and (e) craft an organization to implement whatever plan is agreed to. The need for political action and regulation often arises in efforts to reach and enforce collective agreements in the multiactor context.

Recourse to public ordering, is not, however, the only or always the best response. Private ordering can and has successfully mitigated many common pool problems (Furubotn and Richter 1997, p. 102). Government assistance— for unitizing common pools (such as oil) or for creating markets (as in the creation of tradeable property rights for air pollution)—is often the cost-effective way to proceed.

2.3 Variable Access

The simplest transaction is an outright sale. But even that is complicated by the question of how the property right is defined. As Demsetz observes, ‘To have the right to till a parcel of land is not equivalent to having all the rights to the land. Others may have rights both to minerals contained in the land and to trespass across the parcel. The identification of the owner of the asset is made more difficult by the virtually infinite number of different rights that can be associated with use of a given asset’ (1998, p.145).

Access arrangements other than sale include leasing, tenant farming, inside contracting, and franchising. These can vary in length and protections. Incentives for due care (where the concern is over negligence by the lessee) and assured compensation for unexpired improvements (where the lessor stands to gain by refusing compensation for improvements made by the lessee that extend beyond the length of the lease) are common concerns. Access terms is also an area where the risk of changes in the political rules of the game is a chronic concern, the imposition of rent control being one example and the arbitrary exercise of imminent domain and ‘takings’ by the state being another (Michelman 1967).

2.4 Theory Of The Firm

The theory of the firm poses numerous property rights issues, of which the most famous is the separation of ownership from control to which Adolf Berle and Gardiner Means (1932) made early reference in the context of the large corporation where shareholding is widely dispersed. Thus although shareholders remain de jure owners in the large corporation, effective or de facto ownership purportedly passes to the management. Berle and Means thereupon questioned the presumption that firms are reliably given to profit maximization.

Analytical reactions to this condition of separation have varied. One response has been to dismiss the issue by assuming that competition in product and capital markets is relentlessly taut. As Tjalling Koopmans has observed, however, ‘if this is the basis of our belief in profit maximization, then we should postulate that basis itself and not the profit maximization which it implies in certain circumstances …. It would lead us to expect profit maximization to be most clearly exhibited in industries where entry is easiest and where the struggle for survival is keenest, and would present us with the further challenge to analyze what circumstances give to an industry that character’ (1957, pp. 140–1).

Another response to the separation of ownership from control is to reformulate the objective function to reflect de facto control rights. The sales maximization hypothesis (Baume 1959), growth maximization hypothesis (Marris 1964), and managerial discretion hypothesis (Williamson 1964) are in this spirit. Still another response is to reconceptualize the problem of organization in contracting terms. The ‘nexus of contract’ approach (Jensen and Meckling 1976) brings out agency cost features to which monitoring is a response, while the governance structure approach (Williamson 1975, 1985) treats organization form as a decision variable. According to the latter, hierarchical decomposition principles—especially be- tween centralized and decentralized modes of organization—matter. Organization is thus viewed both as a source of the managerial discretion problem and a partial solution, in that the large corporation can be reconfigured to mitigate some of its own failures.

A ‘modern’ property rights theory of the firm, of which Oliver Hart (1995) is the principal architect, has taken shape more recently. This theory works out of an incomplete contracting setup. The central issue with which this theory is concerned is that of vertical integration: who should own the assets of two related stages of production? This theory illustrates both the strengths and limitations of property rights reasoning. To its credit, the analysis makes clear how the ownership of property rights influences ex ante investments. But this exclusive focus on property rights comes at a cost, in that problems of ex post mal- adaptation are suppressed (by assuming that the parties will costly bargain to an efficient result, whatever the assignment of property rights). The idea that organization matters—that the management of some transactions is better done by markets and of others by hierarchy—is sacrificed in the process.

2.5 Rent Seeking

The de facto ownership of property rights poses numerous intertemporal issues, of which rent seeking is one. The basic rent seeking proposition is this: the creation of ‘rights’ to which supernormal returns potentially accrue invites ex ante prepositioning, thereby to better qualify the applicant bidder for the job or contract in question. For example, the award of a natural monopoly franchise or of a favored class of employment (Civil Service) invites parties to politick to receive the award and to make other efforts to improve their eligibility. Rent protective efforts also ensue (Tollison 1998).

In the degree to which such responses went unnoticed or were ignored by economists, such costs were mistakenly omitted from the original calculus. Upon ‘discovering’ such costs, most economists declared them to be wasteful. That, however, assumes that economics trumps politics (Stigler 1992). If political choices are to be respected, then the best course of action is to recognize that prepositioning is a predictable consequence of efforts to create new classes of rights, whereupon prepositioning effects are folded into the project design calculus. In that event, rent seeking, and its attenuation, are included in the ‘approved plan.’ Those who condemn rent seeking are loathe to come to terms with this proposition.

2.6 Economic Development And Reform

Early development theory emphasized ‘macroeconomic accounting aggregates such as savings and the balance of payments, and the relative balance between broadly defined ‘‘sectors’’ such as ‘‘industry’’ and ‘‘agriculture’’ ’ (Lal 1983, p. 5). When that prescription proved disappointing, the pendulum swung in the opposite direction. The new imperative was to activate the market and ‘get the prices right’ (Lal 1983, p. 107), but that too was overly simple. ‘Getting the property rights right’ seemed more responsive to the pressing needs for reform in Eastern Europe and the former Soviet Union. But while ‘an essential part of development policy is the creation of polities that will create and enforce efficient property rights, … we know very little about how to create such polities’ (North 1994, p. 366). As discussed in Sect. 3.2.2, privatization is important but is not a panacea.

2.7 De Facto Property Rights

Just as the study of contract has benefited by going beyond a legal rules concept of contract to make prominent provision for private ordering (Llewellyn 1931, Galanter 1981), so too does the study of property rights benefit by going beyond de jure property rights to consider de facto. The recent application of de facto reasoning to explain economic development and reform in China (Qian and Weingast 1996) is illustrative. The dilemma was this: de jure privatization was politically unacceptable, yet the state-owned enterprises in China had weak incentives and poor performance. What to do?

Decentralization, by creating local township and village enterprises in which local government remained prominent, turned out to be a productive move. As Qian and Weingast put it (1996, pp. 87–8):

These local government-owned enterprises have remarkably different governance structures from (central) state-owned enterprises and thus face better positive and negative incentives… . Politicians in every political system tend to bail out inefficient firms or spend on wasteful consumption. In a federal system, however, the mobility of resources across regions raises the opportunity costs to local governments of bailing out inefficient firms or wasteful public expenditures.

Not only do local governments share the successes of local enterprises, but they incur the risk that investments will relocate if governments interfere. Federalism is thus an instrument for realizing quasi-privatization and the incentive benefits that accrue thereto. De facto property rights thus vary with the political environment, de jure property rights unchanged.

There are nevertheless limits to the risks that parties will incur in a regime where de jure credibility is lacking. I conjecture that China will experience serious incentive obstacles in its attempts to develop leading edge technologies unless it provides more secure de jure supports for intellectual property rights.

3. Limitations

Although property rights concepts and property rights reasoning have gone a long way to reshape our understanding of economic institutions and effect public policy reform, the early ambitions of the economics of property rights have been incompletely realized. Here, as elsewhere, there can be too much of a good thing.

3.1 Oversimplification

According to Coase, ‘a private-enterprise system cannot function properly unless property rights are created in resources, and, when this is done, someone wishing to use a resource has to pay the owner to obtain it. Chaos disappears; and so does the government, except that a legal system to define property rights and to arbitrate disputes is, of course, necessary’ (Coase 1959, p. 12).

This property rights solution applied not merely in general but even to such apparently intractable problems as allocating electromagnetic spectrum to radio broadcasters: ‘there can be little doubt that, left to themselves, the courts would have solved the problems of the radio industry in much the same way [by defining and enforcing property rights] as they had solved similar problems in other industries’ (Coase 1959, p. 30). Other interested parties were less sanguine. Chief Justice Taft, for example, resolutely ‘dodged the radio question. I have refused to grant writs and have told the other justices that I hope to avoid passing on this subject as long as possible’ (Coase 1959, p. 30).

Indeed, what would the courts, left to themselves, have done? Taft was baffled by the radio question because property rights were ill-defined and the courts did not know how to define them. Awaiting a workable definition of property rights in electromagnetic spectrum—with the help of economists, lawyers, engineers, or managers—a property rights ‘solution’ remained elusive.

As Arthur DeVany put it, ‘the real stumbling-block to a market system of spectrum allocation is the interference problem. The spectrum is a multidimensional space; signals propagate indefinitely in the frequency, spatial, and time domain’ (1998, p. 169). The team of DeVany, Ross Eckhart, Dan O’Hara, Charles Meyers, and Richard Scott (three economists, a lawyer, and a physicist) turned their attention to this matter in 1969. Their best efforts to define property rights that would be ‘exclusive, predictable, capable of subdivision, enforceable and flexible’ (1998, p. 169) notwithstanding, DeVany now concedes that their 1969 definition was merely a template and needed further refinements (1998, p. 169).

Indeed, going beyond the definition of property rights, there is a further problem: how to devise an auction? Although DeVany avers ‘that our model has been used to privatize the spectrum in New Zealand, Australia, and Latin America’ (1998, p. 168), Preston McAfee and John McMillan maintain that ‘simultaneous single-round, sealed-bid auctions were used in New Zealand for spectrum licenses and in Australia for satellite-television licenses with disappointing results: low revenues and inefficient license allocations’ (1996, p. 162). New developments in auction theory, which did not take shape until the 1980s and 1990s, were also needed. The simultaneously ascending auction was adopted by the FCC in the 1990s to auction spectrum for personal communications services: mobile telephones, two-way paging, portable fax machines, and wireless computer networks. Some judge that auction to be a ‘success’ (McAfee and McMillan 1996, p. 163), but the actual sale of spectrum turned out to be ‘more complicated that anything in auction theory’ (McAfee and McMillan 1996, p. 171).

Merely to conduct an auction ought not to be confused, moreover, with full privatization. In the US the FCC remains an active player in the management of spectrum. The upshot is that defining and enforcing property rights for some resources is a daunting exercise. Politics often continue, usually with the active participation of the key players. Realpolitik and partial privatization are evidently bedfellows.

3.2 Overreaching

3.2.1 The Modern Corporation. Might the salient features of the modern corporation be explained in property rights terms? Harold Demsetz took this position. Upon observing that there are ‘significant economies of scale in the operation of large corporations … [and] that large requirements for equity capital can be satisfied more cheaply by acquiring the capital from many purchasers of equity shares’ (1967, p. 358), Demsetz described the modern corporation in the following property rights terms: (a) efficiency is realized by delegating effective ownership to the management; (b) shareholders are essentially lenders of equity capital; and (c) limited liability relieves shareholders of the need to carefully examine corporate liabilities and the assets of other shareholders (as they would need to under partnership law).

This property rights interpretation of the modern corporation over-reaches in the first two respects. First, to suggest that diffuse ownership is responsible for delegation, whereupon the ‘management group becomes the de facto owners’ and that ownership is ‘legally concentrated in management’s hands’ (Demsetz 1967, p. 358) is incorrect. For one thing, delegation is observed in large corporations whether there are many or few owners of equity shares. For that matter, delegation is observed in every large organization—public, private, nonprofit. Well-known limits on the span of control (from organization theory) rather than the economics of property rights are responsible for that result. Additionally, of the three rights of ownership—the right to use, transform, and appropriate the income from an asset—the management is never delegated this last. Equity is the residual claimant.

Second, to describe shareholders as ‘lenders’ of equity capital is misleading. Debt and equity are not merely instruments of finance; they are also instruments of governance. If shareholders are merely lenders, why not just sell collateralized bonds? Or why not loans from the banks? It is not for naught that equity investors, who invest for the life of the firm and are residual claimants, are awarded control of the board of directors (Fama and Michael 1983). The efficiency logic of debt and equity is usefully viewed as a governance issue (Williamson 1988).

3.2.2 Russian Privatization. The architects of privatizing Russian industry in the early 1990s appealed to the modern property rights theory of Sanford Grossman and Oliver Hart (1986) to urge mass and rapid privatization of all sectors of Russian industry (Boycko et al. 1995). The overarching theory was this: ‘When property rights over a productive asset are clearly specified, and the person who decides how to employ his asset bears full costs and enjoys the full benefits of employment, he puts the asset to its most productive use’ (Boycko et al. 1995, p. 19). Upon privatizing two-thirds of Russian industry in June 1994, Boycko et al. boldly declared that privatization had been brought to a ‘triumphant completion’ (1995, p. 8).

Subsequent events have been unkind. Although it may be unduly pessimistic to view Russian privatization as a failure (Braguinsky 1999, Black et al. 1999), it is undisputed that Russian privatization has not been a triumphant success.

Errors of two kinds explain the premature pronouncement of success. First, the property rights theory of the firm suppresses problems of ex post governance by assuming costless renegotiation. That has analytical advantages, but it is also disconnected from reality. Had Boycko et al. inquired into contract implementation, they would have discovered that the efficacy of privatization varies, working much better in some industries than others (Williamson 1976, Goldberg 1976, Priest 1993). Second, Boycko et al. never faced up to lapses in the laws and, even more, their efficacious enforcement in Russia. Failures to look beyond the immediate award of property rights and examine the needs for ex post governance support and effective legal recourse turned out to be fateful.

As with the allocation of electromagnetic spectrum and interpreting the modern corporation, so too with Russian privatization. Thus although property rights reasoning is pertinent to all, the economics of property rights is a self-limiting perspective. Awaiting a unified theory of economic organization, which is not in prospect, the application of several lenses—to include an examination of hazards that beset ex post governance and the condition of the institutional environment—has a lot to recommend it.

4. Conclusions

The economics of property rights is unarguably important. Were it that the Socialist Controversy in the 1930s was less preoccupied with technicalities (such as marginal cost pricing) but addressed itself more to an assessment of the property rights differences between capitalism and socialism, the field of comparative economic systems would have developed very differently (Demsetz 1998). But while property rights are crucial, they are not fully determinative of economic organization. To claim that efficiency will be realized upon defining and enforcing property rights simply over-reaches. Not only can property rights be difficult to define, but best efforts at court enforcement can be costly. Also, property operates in combination with contract and organization.

Kenneth Arrow’s remarks about externalities, market failures, and transaction costs help to restore perspectives: ‘I contend that market failure is a more general category than externality [and, because] market failure is not absolute … , it is better to consider a [still] broader category, that of transaction costs, which in general impede and in particular cases completely block the formation of markets’ (1969, p. 48). Transaction cost is an inclusive concept that applies to property, contract, and governance.

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