Recht und Ökonomie (Law and Economics) Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre http://www.econ.jku.at/schneider Recht und Ökonomie (Law and Economics) LVA-Nr.: 239.203 WS 2012/13 (4) Property Rights WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

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). WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

5. Criteria For an Efficient System of Property Rights Universality Rules must apply to all individuals. Exclusiveness Right to exclude other from use of a resource. Transferability Ability to transfer rights to others. WS 2012/13 Law and Economics

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! WS 2012/13 Law and Economics

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’) WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

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$. WS 2012/13 Law and Economics

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). WS 2012/13 Law and Economics

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: Property rule. Liability rule. WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics

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! WS 2012/13 Law and Economics

9. Factors Advancing the Development of Property Rights Large expected aggregate efficiency gains. Few interest groups. Small differences among groups. General availability of information. Equal distribution of gains and losses. WS 2012/13 Law and Economics 16

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. WS 2012/13 Law and Economics 17

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 to develop new products or processes. Less increase in productivity (efficiency). Example: patent system. WS 2012/13 Law and Economics 18

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!? WS 2012/13 Law and Economics 19

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 WS 2012/13 Law and Economics 20

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! WS 2012/13 Law and Economics 21

11.4. Dynamic Aspects of Patents “Patents encourage inventions and innovation”!? “Patents prevent innovative activities through (threats of excessive) litigation”!? WS 2012/13 Law and Economics 22

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. WS 2012/13 Law and Economics 23

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. WS 2012/13 Law and Economics 24

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! WS 2012/13 Law and Economics 25

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! WS 2012/13 Law and Economics 26

14. Public Goods Essential features of public goods: Non-excludability (of non-payers, free riders); 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. WS 2012/13 Law and Economics 27

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. WS 2012/13 Law and Economics 28

16. Regulation Property rights remain with original owner. Limitations placed on the usage of resource. Regulation frequently occurs in the context of privatization. Complex and detailed legal requirements. Example: bus service: prices, frequency of service, quality, dynamic adjustments, … Company is better informed than regulator! WS 2012/13 Law and Economics 29

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 marginal cost of different levels of abatement! Total activity test: maximize net wealth! Optimal abatement vs. separation of activities. WS 2012/13 Law and Economics 30

18. Exchange and Transaction Costs Transaction costs  costs of exchange. Steps of an exchange: Search costs (for exchange partner). Bargaining costs (negotiations). 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. WS 2012/13 Law and Economics

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. WS 2012/13 Law and Economics