From the scope of the institutional-economic analysis, further attention is directed to the formal rules and to the property rights theory. This chapter provides an outline of current thinking in regard to the property rights theory by presenting the assumptions of property rights, the notion and deconstruction of property rights, the role of transactions costs, and political power in the interpretations of the evolutionary character of property rights. Finally, this chapter explains how property rights theory can be applied to planning and development issues. This chapter also includes a discussion on how to improve market efficiency based on the property rights theory. This discussion contains e.g. the approach of ‘spontaneous’ versus
‘planned order’ (Webster and Lai, 2003), the approach of ‘structuring’ versus ‘regulating’ the market (Needham, 2006), and ‘the compensation rules’ by Van der Krabben (2009).
This chapter aims to identify the curtail elements in the property rights theory, which can be used in further discussion on influence of the property rights regime on land development processes. In this chapter the concept of the property rights regime is elaborated.
3.1 Introduction to property rights theory. How property rights emerge?
The foundation of the study of property rights (and transaction costs) rests in the Coase Theorem as discussed in Chapter Two: “When rights are well defined and the cost of transacting is zero, resource allocation is efficient and independent of the pattern of ownership” (Coase, 1960). The foundation for the property rights theory was also formed by Alchian (1965, 1969), Demsetz (1964, 1966, 1967), Alchian and Demsetz (1972, 1973), Cheung (1968, 1969, 1970, 1973), and Furubotn and Pejovich (1972, 1973, 1974), among others. Further theoretical and empirical contributions to this earlier stream of research literature, which is referred to as the ‘classical property rights theory’ (to contrast with modern property rights theory), have been made by North (1981, 1990), Barzel (1982, 1997), Cheung (1983, 1990), Libecap (1989), Eggertsson (1990), and Alston et al. (1996), among others. In addition Grossman and Hart (1986) and Hart and Moore (1990) also contributed to the development of the property rights theory. Their contribution in the research literature is called the ‘modern property rights theory’ sometimes called the ‘GHM model’) (Kim and Mahoney, 2005).
The ‘classical’ form of the property rights theory focuses on the historical and institutional context that shapes and changes property rights (and therefore led to ‘getting the incentives right’). The ‘modern’ version of the property rights theory, utilizing advanced mathematical tools, attempts stylized modelling of ownership and incentive structures (Kim and Mahoney, 2005). In this thesis focus is given to the ‘classical’ property rights theory and its application to planning and development issues.
The following basic concepts in the property rights theory will be introduced at the beginning:
- Rights in land can include more than the right of ownership. Property rights can be divided into several different partial rights (bundle of rights). Multiple dimensions
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of property rights have the important economic implication that many different people are able to hold parts of the rights to a property
- The actor who owns a part of the property rights of a resource is called the residual claimant
- All economic activities including trade and production are exchanges of bundles of property rights (Furubotn and Pejovich, 1972)
- Attributes to which rights are not assigned by formal or informal contract – or resources with unclear property rights - are said to be in the public domain
- Economic concepts of property rights can be distinguished from legal concepts of property rights. Barzel (1997) views that the most relevant concepts of property rights are the economic rights. Kim and Mahoney (2005) attempt a balanced theoretical approach in considering the economic aspects of property rights as a complementary concept within the legal framework that allows such property rights legal protection and third-party enforcement.
The key point of the property rights theory is that property rights matter and provide the basic economic incentive system that shapes resource allocation. Or put differently, an important insight of the property rights theory is that different specifications of property rights arise in response to the economic problem of allocating scarce resources, and the prevailing specification of property rights affects economic behaviour and economic outcomes (Coase, 1960; Pejovich, 1982, 1995). Buitelaar (2002) connected the property rights theory to transaction costs theory and explained it in the following way:
“The central assumption behind the property rights paradigm is that the better the property rights are delineated and the lower the transaction costs, the better the parties involved are capable of internalizing externalities. According to the institutional economists, the existence of transaction costs is a fundamental element in the emergence and evolution of property rights.”
Therefore, e.g. in relation to functioning of land and property markets, property rights should be delineated and assigned to improve market efficiency, i.e. to reduce externalities. This should be achieved by reducing transaction costs and, if those cannot be reduced to zero, reassigning and redelineating property rights over land. (see also Van der Krabben, 2009) However, there is no one clear approach among the institutional economists concerning the emergence and evolution of property rights. Earliest property rights theorists such as Demsetz (1967) were optimistic about the evolution of property rights turning towards an economic efficiency. Demsetz (1967) defines the property rights in the following way:
“Property rights convey the right to benefit or harm oneself or others. Harming a competitor by producing superior products may be permitted, while shooting him may not.
A man may be permitted to benefit himself by shooting an intruder but be prohibited from selling below a price floor. It is clear, then, that property rights specify how persons may be benefited and harmed, and, therefore, who must pay whom to modify the actions taken by persons. The recognition of this leads easily to the close relationship between property rights and externalities (…). No harmful or beneficial effect is external to the world. Some person or persons always suffer or enjoy these effects. What converts a harmful or beneficial effect into an externality is that the cost of bringing the effect to bear on the
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decisions of one or more of the interacting persons is too high to make it worthwhile, and this is what the term shall mean here. “Internalizing” such effects refers to a process, usually a change in property rights, that enables these effects to bear (in greater degree) on all interacting persons.”
Demsetz (1967) argued that a primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities, i.e. the internalization of beneficial and harmful effects. According to him, “the emergence of new property rights takes place in response to the desires of the interacting persons for adjustment to new benefit-cost possibilities”. In addition the gains of internalization of property rights should be larger than the cost of internalization in order to develop the new property rights. Therefore he has argued that “property rights arise when it becomes economic for those affected by externalities to internalize benefits and costs”. Hence, the forces which will govern the particular form of right ownership (“some broad principles governing the development of property rights in communities oriented to private property”) are the market prices or production possibilities or other possibility of profits.
Therefore, earliest theories concerning property rights assumed that the institutional environment is changing towards economic efficiency through the influence of market forces.
Precisely, institutions evolve over time in search of more efficient allocation of rights and institutions tend to move towards more efficient economic solutions through negotiations between the interested contractual parties. Libecap (1989) in his research book “Contracting for property rights” as well as also North (1990) “Institutions, Institutional change and economic performance” provide facts that challenge this earlier optimistic assumption (Mahoney, 2005).
North (1990) argues that in a world of zero transaction costs, this economic process would be immediate and efficient. However, if transaction costs are positive and non-negligible, this economic process may be more gradual, and in some economic cases may result in failure to reach contractual agreement. According to Libecap (1989)40 the property rights formation is a more complex process than assumed by theories derived from neoclassical approaches and earlier institutional analysis literature. He convincingly argues that the assumption that property rights will naturally move toward economic efficiency is frequently glib and inaccurate (Mahoney, 2005). Libecap (1989) uses the term ‘contracting’ in order to describe
“efforts by individuals to assign or to modify property rights”. These efforts involve either negotiations among immediate group members or lobbying activities that take place at higher levels of government:
-‐ “bargaining among private claimants within groups to adopt or to change group rules and customs regarding the allocation and use of property
-‐ lobbying and political negotiations among private claimants, bureaucrats, politicians, and judges to implement or to alter more formal property laws and administrative rulings”.
The book of Gary D. Libecap (1989) was an important contribution to the development of property rights theory. It gives a better understanding of the political negotiations underlying
40 See also Alston et al.,1999
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property rights and the interest of parties involved. Libecap discusses the way, in which property rights are formed and the processes by which property rights are changed. It can be seen from this book that the state does not always act to minimize costs and maximize economic value. In particular, Libecap deals with the question of why property rights take so much variety in the form and concentrate on the actual process by which property institutions change.
Libecap (1989, p.10) has noted that the nature in which property rights are defined and enforced fundamentally impacts the performance of an economy for at least two reasons:
- “First, by assigning ownership to valuable resources and by designating who bears the economic rewards and costs of resource-use decisions, property rights institutions structure incentives for economic behaviour within the society.
- Second, by allocating decision-making authority, the prevailing property rights arrangement determines who the key actors are in the economic system.”
Because of this he argues that it is important to analyze how various property institutions emerge. We learn from Libecap’s book about the importance of distributional conflicts among interests groups41 in shaping the institutional structure. In particular we learn about the influence of political entities on the processes of property rights formation and the conflicting interests and bargaining strength of those affected (“political bargaining or contracting underlying the establishment or change of property institution and the motives and political power of the various parties involved”). Because certain property rights arrangements can reduce transaction costs and encourage investments there is public good aspect involved. As with all public goods, the process of creating or modifying property rights is always exposed in distributional conflicts and bargaining strength of those affected. Distributional conflicts are concerned with different expectations of gains among participants. Therefore property rights formation is “determined through the political process, involving either negotiations among immediate group members or lobbying activities at higher levels of government”. In the political bargaining over institutional change, the positions taken by the various bargaining parties, including for example private claimants, bureaucrats, and politicians, will be moulded by their private expected net gains, as well as by the actions of the other parties.
The private net gains are determined by the individual’s anticipated share in the aggregate or social benefits of certain property rights arrangements. In addition, the political process of defining and enforcing property rights can be divisive because of the distributional implications of different property rights allocations. If influential parties cannot be sufficiently compensated, beneficial institutional change may not occur. Even though society would be better off with the public good, the potential economic gains fostered by the proposed arrangement will be forgone by opposing of institutional change by influential parties. (Libecap, 1989)
Consequently, Libecap (1989) argues that distributional conflicts, and efforts to address such conflicts are difficult to predict and can block institutional change. The property rights arrangement which ultimately emerges as institutional change, bears little resemblance to that which was initially proposed.
41 The three main interest groups, which were distinguished by Libecap, are: private claimants, politicians, and bureaucrats.
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“In principle, it is possible to construct a side payment scheme that would compensate those who otherwise would oppose a desirable change in property rights. But in practice, devising perfectly compensating side payments to bring agreement encounters formidable obstacles, including questions of who would receive side payments, who should pay, what size the compensation should be, and what form the compensation should take”. Libecap (1989, p.6)
In the property rights theory there is no one clear approach to the emergence of the property rights. Libecap assumes that certain distribution of property rights can reduce transaction costs but the transaction costs are not explanatory variables. On the other hand, Webster and Lai (2003, p.3) argue that: “Institutions emerge to reduce transaction costs and more generally, the costs of voluntary co-operation. Markets are institutions that reduce the costs of organizing a multitude of individual transactions. Government edicts, policy and regulations are institutions that reduce the cost of collective transactions”. Barzel also emphasised the importance of transaction costs in a foreword to the book of Webster and Lai (2003, p.vii). He summarised that the theory of property rights offers the following fundamental three-part proposition:
1. “Subject to the costs of transacting, individuals will organise and allocate their rights so as to maximise their joint wealth
2. The level of wealth is enhanced when economic rights are allocated such that individuals bear more of the effects of their actions; that is, they reap higher rewards from inducing gains for others and conversely suffer heavier penalties from inducing losses.
3. Because the costs of transacting are positive, the Pareto conditions are never met.”
Van der Krabben (2009) also argues that the degree to which ownership is established over a commodity’s separate attributes depends on the costs of creating and policing contracts that establish that ownership – that is, transaction costs. Transaction costs can be defined as the cost associated with transfer, capture and protection of rights.
Therefore there are different approaches concerning emergence and evolution of property rights. One, which emphasises the transaction cost as a main factor underlying the emergence of the property rights. This approach stresses the importance of transaction costs as an explanatory variable. The second is the approach of Libecap emphasising the political processes of defining and enforcing property rights.
In response to Libecap’s position in Webster and Lai (2003, p.5) we can find: “Self-regarding endeavours can lead to zero-sum result: rent-seeking groups using their position to create artificial income for themselves at the expense of other groups; corrupt officials, workers and politicians poverty stealing the principal’s resources; indolent managers, politicians, professionals and workers free riding on others’ labour.”
Also Needham (2006) criticized indirectly the Libecap position. Libecap’s position refers to the public choice theory which assumes that a state agency does not act in the public interest.
Needham (2006, p.62) criticized the public choice theory approach, he pointed out that:
“Public choice theory does not convince me. A healthy scepticism towards state agencies is warranted; automatic cynicism is not. If a positive planning theory (Poulton 1991) based on
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empirical research shows that state agencies sometimes act to promote the interests of politicians and civil servants, this has to be taken into account when evaluating public policy.
But that is different from assuming that state agencies do nothing other than that. Public choice theories, however sophisticated, do no justice to the complexities of local and national politics, nor to the realities of what state agencies do, nor to the constrains on arbitrary and self-seeking action imposed by long-established institutions (Hoogerwerf 1995).”
Webster and Lai (2003, p.3) argue that “institutions reduce transaction costs by assigning property rights over scarce resources”. But if the right to benefit from a resource is assigned but problematically divided between several different residual claimants, does it mean that this situation reduces transaction costs? If resources would be left in the public domain, government could use it to increase economic growth. In addition as long as access to, and use of, public property is subject, as it usually is, to restrictions – such as prohibiting the hunting of young game animals – one cannot conclude that rights would be better delineated under private ownership than they are under public ownership (Barzel, 1997, p.100).
There is also an argument against the transaction costs from Needham (2006, p.50) concerning the diversity of the property rights arrangements, as he puts it: “And finally we mention the theory that property rights within a society evolve as technology changes, as population grows, and so on, in such a way as to make it possible to achieve higher economic efficiency under the new circumstances. Ellickson (1993: 1392) says ‘Land regimes evolve in pragmatic fashion to exploit scale efficiencies and spread risks.’ If this theory is true, then all countries which adapt to the same technological changes will tend to have the same land system.” Therefore the transaction cost explanation ignores the social embeddedness.
Needham (2006, p10-11) continues: “We must not forget, however, that there can be great inertia in rights in land. Often it takes a long time to change them. One reason is that they represent deeply rooted moral beliefs. Many of the changes are fairly marginal and have the form of forbidding what previously was a presumptive right. For example, I might think that I have the right to play music in my back garden: the neighbour asks me to make less noise: I refuse for I regard playing music as my presumptive right: the neighbour tries to get the court to stop me: the judge says that the neighbour has no right to no noise nuisance from me (my presumptive right is confirmed by law): changes in electronics make it possible to play music louder and louder: the interests of so many people are so harmed by this that politicians take up the cause: then the lawmaker gives people a right to freedom from loud music from their neighbours. The law has been changed. A new right in land has been created.”
Therefore, the next perspective in the discussion on why property rights emerge, refers to the fact that property rights are socially constructed. In addition there is also the theory of path dependence. Libecap as well as North (1990) emphasized the roles of time and legal precedent in historical path dependences for institutional change (important historical path dependence in determining the kind of property rights that can be adopted at any time). North (1990) argues that the high degree of path-dependency of a given institutional framework is an important factor in explaining persistent low growth rates in developing countries. More precisely “an initial set of institutions that provide disincentives to productive activity will create organisations and interest groups with a stake in the existing constrains”. Past decisions concerning property rights arrangements can be seen as a limit of possible institutional solutions. “Past political agreements on property institutions create the
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framework for responding to new common pool losses, the identities of the agents for and
framework for responding to new common pool losses, the identities of the agents for and