BSM940 Economic Environment of Business

Lecture 6

Property rights and contracts

Prof. Tomasz Mickiewicz Aston Business School, Economics & Strategy

Private property rights

Private property rights establish a relationship between defined individuals and defined assets, which can be physical goods, ideas or people own bodies. Free use of property is limited only by the rights of others. In case of damage, onus of proof lies with the claimant this is important because proving the claim is an important material constraint on excessive limitations of free property use. Uncertainty among investors about the security of their property rights in their capital and its prospective returns may lead to underinvestment, capital flight and poor economic performance.
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Special types of property: intellectual property, self-ownership

Property rights can also be attached to identifiable bits of knowledge. Producing knowledge is a risky undertaking and people will engage in it if the owners of valuable knowledge will be allowed to reap material benefits from sharing it with others. Slavery is seen as a violation as a basic human right to self-ownership. But self-ownership also applies to the right to use own skills and efforts to the best benefit. Restrictions on movement of people, compulsory union membership and minimum wages are all violations of this basic right.

Excludability
Excludability is the defining characteristics of property rights. It means that others can be excluded not only from the benefits of an asset, but also that the owners are exclusively responsible for the costs of assets uses, as well as the costs of ensuring exclusion. Excludability is important in ensuring that private property uses are steered to reflect what others want. The incentive to deliver what other want works through the profit-loss signals.
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Externalities
Externalities are benefits and costs of property use that do not impact on the property owner, but impact on others. Externalities arise when there are knowledge problems. It is sometimes too costly to monitor the effects of use of property (high transaction costs). For example: neighbours benefits from my investment in vaccination, or neighbours costs of producing smoke from a fireplace. It implies we cannot relate those effects to property in well-defined way. Where techniques of measurement improve (e.g. IT), excludability may become feasible and externalities can be converted into internalised benefits and costs. In that case, property owners will again be guided voluntarily by profits and losses expected from their bilateral contracts.
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Coase versus Pigou

Pigou (1930s): the problem of externalities should be solved by the government taxing those property uses that cause external costs and subsidizing uses that cause external benefits, as well as compensating those bore the impact of external costs. The assumption is that government officials:
can assess the costs and benefits, and will have incentives to implement optimum solution

Coase (1960) demonstrated that taxes and subsidies are not necessary to remedy the problem of externalities. Those who caused external costs and those who were impacted could get together to bargain and exchange property rights, provided transactions cost were not too high.
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Coase Theorem and efficiency of law

Coase theorem: If rights are well-defined and transferable and if transactions costs are not too large, then the initial distribution of property rights is irrelevant for achieving efficiency, because parties can enter into free exchange and the rights will move to their highest value in use.

Thus, efficient design of the legal environment implies a structure of law that makes transaction costs low in order to facilitate exchange of rights, which in turn maximises value.

Forms of Property

Source: Kasper, Streit, Boettke

Exclusion costs
Exclusion costs are incurred when owners employ resources to exclude others from owning or using their property. High exclusion costs lower the value of property. They depend on institutional arrangements, beginning with underlying standards of ethics that are shared in the community. Differences in institutional systems have great influence on exclusion costs and therefore property values. Property owners, when they have a chance, shift their property to environment where it is well protected and hence highly valued. In many developing countries people enjoy little effective protection of their property: they are frequently subject to rackets and excessive regulations; many experience the property risks of war and civil conflicts. In contrast, when exclusion costs are reduced, people find it more attractive to acquire and activate property, thereby helping themselves out of their poverty. 9

Question
For 5 minutes, please discuss with the person next to you Please find examples of products and services around you with (a) low, and (b) high exclusion costs. What could be done about it?

Exclusion costs: follow up

When property rights are ill defined and poorly protected by legal means, people may try to define and protect them for themselves. This is the origin of protection rackets by the Mafia and self-help organizations (vigilantes), which take the law into their own hands. The danger however is that those self-appointed violence professionals: use their means of coercion to extract high prices for the protection, or that rival gangs fight over the clientele of property owners, causing collateral damage among innocents. In such a situation, collective, law-bound government can offer great reduction in exclusion cost to property owners. Respect for private property is low where wealth distribution is widely perceived as unjust (e.g. originated with oppressive politics, like in much of Latin America or Africa or grabbing of former state property by oligarchy like in Russia). 11

Divisibility and Transferability

Divisibility means that property rights can be unbundled. In particular, core (passive) ownership rights can be separated from rights to specific uses of an asset, for example: The title to a lake being separated from the right to fish in the lake or the right to swim in it, Those who have the title to a forest assign differentiated right to hunt, to go for walks and invest in tree growing Ownership in a company is divided into shares. Property should be disposable (transferable): the owners retain the right to transfer the ownership, for example through sale, inheritance or donation. When property is tied to the owner that prevents others who may value the property more highly (because of their better knowledge and skills) from making better use of it.
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Transactions costs of using property rights in economic cooperation

Property rights are used in exchange via voluntary contracts which establish a binding agreement to: a) Pay an agreed price, b) To hand over property rights as agreed. If (a) and (b) occurs simultaneously the transaction costs are low, however this relates only to simplest forms of exchange. If (a) and (b) are separated over time, contracts have to include provisions for credible commitments that the obligations will indeed be fulfilled. Sanctions have to be provided against opportunistic non-fulfilment, and provisions need to be made for sorting out subsequent misunderstandings or disagreements. Creating credible commitments is a key problem of cooperation, for example: Hostages can be used, where contracts are protected by the other party having a special claim on specified asset in case of non-fulfilment (e.g. mortgage) Intermediaries who have a reputation to lose (e.g. banks) join contracting parties (e.g. savers and investors) as a middleman who offer more credible safeguards. 13

Open-ended, relational contracts

In relational contracts not all eventualities can be foreseen, let alone regulated by contract provisions. A typical example is an employment contract. Given uncertainty and the costs of drafting and negotiating, the contract can never enumerate and regulate all aspects of the deal, in particular if it extends over a long period of time. Thus, contracts have to rely on universal, abstract institutions within which specific eventualities can be settled in reasonably predictable ways. General legal principles such as acting in good faith or dead is a deal are rules that enhance trust in contract. In contrast, simpler, non-relational contracts can be standardized, saving on knowledge, negotiation and enforcement costs (e.g. letting agreement).
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Transaction costs of market contracts versus organisation costs of firms

Transaction costs are coordination costs that are incurred when property rights are exchanged in market transactions. They consist of:
Ex ante

Ex post

Information search costs (to find a sufficient number of exchange partners, their location, product design, quality, reliability) fixed, sunk costs of transactions Costs of negotiating, concluding and monitoring the contract Costs of adaptation re-negotiating contracts when conditions change, and cost of possibly dealing with contract breaches (recurrent costs of transaction).

In some occasions coordination costs of market transactions are higher than organization costs of entering into open-ended, semi-permanent hierarchical arrangements that are called firms.

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Relational contracts: self-enforcement

In advanced market economies, many property uses are based on contractual relationships, which depend as much on self-enforcement mechanisms as on reliable external enforcement. a) Profitable businesses relations extend over a long time. In such cases tit-for-tat responses can be a powerful sanction. Also, in well identified trading communities, sanctions may take the form of exclusion of offending parties from future trade (ostracism). Merchant habits and virtues develop over time reducing transaction costs. b) Credibility of commitments in enhanced when there are gains from building a reputation. This works in trading communities when information is communicated and some basic values (that define reputation) are shared.
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Relational contracts, self-enforcement and the judiciary - more

c) Self enforcement is enhanced by the introduction of third parties (intermediaries). For example, these can act as guarantors. d) Prior agreement on an adjudicator: an independent person or organisation asked to look into a conflict and to give a verdict. A stronger form is compulsory arbitration, a contract provision that binds the parties to accept the verdict in case of dispute. e) Contact enforcement may depend on a third party who enters as a directly involved intermediary: the middleman., who conduct back-to-back transactions on their own account. Apart form helping with information search, they fulfil the important role of offering trust in contract fulfilment.
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Readings
For this lecture please read Kasper et al., chapter 7.

Topic for tutorials: decentralisation

Second Round Readings: Jean-Francois Hennart (1993). Explaining the Swollen Middle: Why Most Transactions Are a Mix of "Market" and "Hierarchy. Organization Science. Vol. 4, No. 4, pp. 529-547. Robert S. Kaplan (1984) The Evolution of Management Accounting. The Accounting Review, Vol. 59, No. 3, pp. 390-418.