Prof. Dr. Friedrich Schneider
Institut für Volkswirtschaftslehre
http://www.econ.jku.at/schneider
Recht und Ökonomie
(Law and Economics)
LVA-Nr.: 239.203
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(4) Property Rights
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1. Definition of Property Rights
 Property  a bundle of rights.
 A method of assigning to particular individuals or
groups the ‘authority’ to select any use for specific
resources.
 Goes beyond legal definition since it includes also
social norms.
 Property rights consist of:
 rights of use;
 rights to the return from use;
 rights to transfer those rights.
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2. Private vs. Common Ownership
 Private ownership:
 Individuals.
 Clearly defined (small) groups of individuals.
 Common ownership:
 Only members of a group have access to resource.
 Public in general owns property rights.
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3. Private Property Rights Theory
 How are the sanctioned behavioural relations among
individuals with respect to the use of resources or
goods organized?
 Specification of norms to be observed:
 Limitations of use (e.g. zoning laws: no factory in
residential neighbourhoods).
 Restrictions on returns (e.g. price controls, taxation)
 Specific rules for transfer (e.g. land).
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4. Incentives in a Property Rights Framework
 Design of property rights is economically important.
 Actions usually cause cost and lead to returns
(e. g. investment).
 Will the returns accrue to the individual that incurs the
cost?
 Efficient incentives require:
Decision maker has to bear all cost and should receive
all returns  principle of internalization.
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5. Criteria For an Efficient System of
Property Rights
(1) Universality
 Rules must apply to all individuals.
(2) Exclusiveness
 Right to exclude other from use of a resource.
(3) Transferability
 Ability to transfer rights to others.
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5.1. Universality
 Assume a society without property rights.
 Example: farmer sows, but since there is
 no ownership of land, and
 no protection against someone else harvesting,
additional cost arise:
 guarding the harvest!
 looting someone else’s harvest!
 More efficient: legal protection.
 Establish property rights!
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5.2. Exclusiveness
 Possibility to exclude others from using the resource –
within legal limits
 Creates incentives to take measures to
 increase value of resource, and/or
 avoid damaging activities.
 Incentive to invest: Both risk and potential return are in
the domain of the individual.
 Alternative: common ownership leads to inefficiency –
overuse! ( ‘tragedy of the commons’)
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5.2.1. ‘Tragedy of the Commons’
 Example: commonly owned grazing land.
 Each member of the community wants to maximize profits: equate
 marginal cost – additional cow – and
 marginal revenue – additional milk or meat.
 Neglected: ‘cost’ inflicted upon other members of the community
 less grass, lower yield.
 Result: overuse, suboptimal.
 Can be applied to fisheries, hunting, …
 Solution:
 joint decision by all resource users, or
 individual private property of grazing land  user fee.
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5.3. Transferability
 Remember: concept of opportunity costs.
 If a resource is valued differently by two individuals the
one with the highest valuation should receive it.
 Example: a piece of land is valued at 100$ by person A
(the current owner) and at 150$ by person B (potential
buyer).
 Achievement of higher return by transferring it from A
to B at a price between 100$ and 150$.
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5.3. Transferability (cont.)
 Transferability is important for division of labour.
 Rights can also be transferred partially, e.g. leasing
transfers the right to return, not ownership!
 Important concept: transaction costs (TC).
 Postulate: TC should be kept as low as possible!
 Well functioning markets and well functioning legal
systems (enforcement of contracts!) help to reduce
transaction costs ( minimize TC).
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6. Protection of Property
 Protection provided privately or by the state.
 Substitutability of private and public protection.
 Who pays (how much) for public protection?
Problem of public goods  non-excludability!
 Also important: social norms.
 In principle, there are two rules for protection:
(1) Property rule.
(2) Liability rule.
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6. Protection of Property (cont.)
 Example: hydro-electric power plant (HEP) floods land
owned by farmers (F).
 HEP should be built if (expected) return is larger than
(expected) return on e. g. farmland.
 Assume negotiation costs HEP and F are zero!
 Property rule requires farmers (F) to agree – payment:
 Contracts between HEP and F are needed.
 Liability rule entitles F to damages:
 No contracts, but assessment by third party
required.
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7. The Role of Transaction Costs
 Without transaction costs both rules lead to the same
payment (fairness assumed!)!
 Transaction costs / problems with property rule:
 Negotiations with owners of farmland (how many?).
 ‘Holdout’ problem: last negotiating owner (e.g.
parcels of land for one infrastructure project).
 Transaction costs / problems with liability rule:
 Cost of assessment, legal cost, …
 Size of damage: difference between subjective and
objective value of damage.
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8. Independence From Assignment of
Property Rights
 Again assume no transaction costs!
 Important result: the outcome (solution) of the problem
at hand will be independent of the original ownership
of the resource (here land):
 When net return is positive, hydro-electric power
plant (HEP) will be built!
 Relevance of original ownership only for distribution:
 If HEP is given the right to flood, its profits will be
higher since no payments to F are required!
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9. Factors Advancing the Development of
Property Rights
Factors:
 Large expected aggregate efficiency gains.
 Few interest groups.
 Small differences among groups.
 General availability of information.
 Equal distribution of gains and losses.
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10. Implementation of Property Rights
 Define and delineate legally enforceable property
rights (PRs).
 Provide rules for transfer of rights.
 Provide procedures for creation and recognition of
new PRs.
 Establish a system to resolve disputes (procedures,
remedies, penalties).
 Guarantee certainty and stability in PRs.
 Allow for adjustments to new needs.
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11. Intellectual Property Rights
 Patents, copyrights, trademark, trade secrets.
 Why is special protection required?
 Copying is easily possible.
 Development cost could not be recovered.
 Little incentive
processes.
to
develop
new
products
or
 Less increase in productivity (efficiency).
 Example: patent system.
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11.1. Patents: Definition and Advantages
 Temporary exclusivity for non-obvious and novel products or
processes.
 Create exclusive property right in an invention. Two dimensions:
 Breadth (broad / narrow).
 Duration (time period).
 Patent is publicly disclosed (no Public Good).
 But copying is prevented!
 Complements / substitutes can be developed.
 Alternative to patent: trade secret gives ‘first mover’ advantage,
no developments possible!
 Too little technical progress without patents!?
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11.2. Patents: Drawbacks
 Patents (potentially) create monopolies:
 Prices above MC, loss in consumer surplus.
 (Partial solution: price discrimination.)
 Static inefficiency
 (Excessive) market power deters entry and thus
(potentially) the development of competitive products
or more efficient processes.
 Dynamic inefficiency
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11.3. Patens: Time Length of a Patent
 What is the optimal life time of a patent?
 The number of years that equalizes:
 marginal social benefits of inventive activity to
 marginal social cost (higher prices, lower output).
 How broad should a patent be granted?
 Greater patent breadth means larger social loss:
• there will be fewer close substitutes, more protection;
• (example: aircraft as a whole or individual parts?)
 Optimal: variable length, specificity!
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11.4. Dynamic Aspects of Patents
 “Patents encourage inventions and innovation”!?
 “Patents prevent innovative activities through (threats
of excessive) litigation”!?
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12. Monopoly
 Causes for Monopoly:
 Unique PRs over important resource (e.g. network).
 Exclusive PRs conferred by government .
 Large minimum size (relative to market demand).
 Increasing returns to scale.
 Consequence: economic inefficiency.
 Solutions:
 Increase competition – domestic or foreign.
 Competition policy: antitrust, cartels, mergers, …
 Regulation of prices, service, …
 Public ownership.
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13. External Effects
 Activity of one economic actor has an impact on another actor’s
property rights.
 Focus on negative external effects  action leads to a reduction
in value of property.
 Consequence: economic inefficiency  output is too large.
 Solution: internalize externalities:
 command or forbid by law;
 establish procedure to obtain operating licence;
 use taxation;
 devise trading system for damages.
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13.1. Externalities and Property Rights
 Theorem: “If transaction costs are zero then the
original assignment of PRs is of no relevance for the
resulting allocation.”
 Distribution may very well be affected.
 Basic principle (again): unambiguous PRs-assignment
leads to optimal outcome.
 Important: zero (or near zero) transaction costs.
 Devise legal system to minimize transaction costs!
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13.2. Example: Railroad & Farmland
 Railroad (RR) causes damage to land  external effect
on land owners.
 Will there be a railroad?
 Emission right for RR is valued at 1,000$.
 Emission reduces value of land by 500$.
 If RR has right to emission – Yes to RR!
 If land owners have the right to no (zero) emission: RR
must pay compensation, between 500$ and 1,000$ –
Yes to RR!
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14. Public Goods
 Essential features of public goods:
(1) Non-excludability (of non-payers, free riders);
(2) Non-rivalry (by additional consumers).
 Examples:
 fireworks, street lighting, national defence, …
 Individuals will not reveal their true willingness to pay.
 Service will not be offered by a private market.
 Government should provide the service.
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15. Expropriation
 In economic terms: forced sale.
 Preferred: voluntary sale.
 Problem of (sequential) negotiations.
 Crucial question: What price should be paid?
 Objective vs. subjective valuation.
• Objective: discounted present value of income stream.
 Maximization of welfare requires:
 Public value of resource > private opportunity cost.
 Again: consideration of transaction costs.
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16. Regulation
 Property rights remain with original owner.
 Limitations placed on the usage of resource.
 Regulation frequently
privatization.
occurs
in
the
context
of
 Complex and detailed legal requirements.
 Example: bus service:
 prices, frequency of service, quality, dynamic
adjustments, …
 Company is better informed than regulator!
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17. Incompatible Use: Bargaining
 Nuisance – how to reconcile incompatible property
usage (usually land use).
 Examples: noise vs. tranquillity; polluted vs. clean
air; traffic vs. ban on driving, …
 Marginal abatement test:
 Activities coexist: minimize
different levels of abatement!
marginal
cost
of
 Total activity test: maximize net wealth!
 Optimal abatement vs. separation of activities.
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18. Exchange and Transaction Costs
 Transaction costs  costs of exchange.
 Steps of an exchange:
1. Search costs (for exchange partner).
2. Bargaining costs (negotiations).
3. Enforcement costs (monitoring performance; punishing
violations of agreement).
 Search costs: tend to be high for unique goods and services, and
low for standardized goods and services.
 Bargaining costs: bargaining becomes more costly and difficult
as it involves more (than two) parties.
 Enforcement costs: arise when agreement takes time to fulfil.
Low when violations of agreement are easy to observe and
punishment is cheap to manage.
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18. Exchange and Transaction Costs (cont.)
Table: Factors affecting size of transaction costs (TC).
Lower TC
Higher TC
Standardized goods or services
Unique goods or services
Clear, simple rights
Uncertain, complex rights
Few parties
Many parties
Friendly parties
Hostile parties
Familiar parties
Unfamiliar parties
Reasonable behaviour
Unreasonable behaviour
Instantaneous exchange
Delayed exchange
No contingencies
Many contingencies
Low costs of monitoring
High costs of monitoring
Cheap punishments
Costly punishments
Source: „Law & Economics“ (Robert Cooter & Thomas Ulen, 5th ed., 2008), p. 94.
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