Theory of property rights

The theory of property rights has three parts. First, the concept of a property right is defined. Second, alternative systems of property rights are delineated. Third, the assignment of rights under different property rights systems is examined for the implications for efficiency of resource use.

In the theory of property rights, the definition of a property right incorporates more than the ability to obtain the potential reward  or return from a resource. A property right also includes the right to use a resource and the right to alter or modify the resource (Furubotn and Pejovich, 1972, 1974c). These last two characteristics of a property right (that is, use and alteration of a resource) specify the control rights, or the right of residual control. The right to the return is derived from the right to lease or sell the resource and is the residual right. Full owner- ship includes both control rights and the residual rights. The distinction between control rights and residual rights is important in the analysis of decision making. In complex organizations the individuals who con- trol resources and the individuals who obtain the return from resource use are not likely to be the same (Fama and Jensen, 1983a).

There are important and essential characteristics to the definition of the control rights and residual rights that comprise a property  right. These are: (1) how clearly the right is defined; (2) exclusivity of the right; and (3) transferability of the right. Property rights are usually defined through society’s laws or regulations. Sometimes, however, the  defini- tion of a property right is derived from custom or social tradition in a community (Furubotn and  Pejovich,  1972,  1974c  and  Demsetz,  1967). A clearly defined property right states the extent of the use and/or alter- ation of a resource that is permitted.

The value of a property right is affected by how clearly defined the right is. Whether clarity increases or decreases the value depends on the property right in question and the form of clarification. In general, a more clearly defined right has greater value than one where the asso- ciated rights are less well defined. In some cases, however, a clarification of right, say, through the courts or through regulation, can limit the right and possibly lower its value from what it had previously been. For example, a zoning regulation may permit the owner of real estate to rent the property to a single family or tenant but not to multiple tenants. The regulation may reduce potential rental income, lowering value. Alternatively, the regulation may have the effect of increasing or maintaining neighborhood quality and potential resale value. In some housing developments community associations place restrictions on modifications that may be made to the structure of the property owner’s home or garden. These restrictions are designed to maintain or improve long term property values.

The second characteristic in the definition of a property right is its exclusivity. The holder of an exclusive property right is legally permit- ted to withhold use of the resource to other individuals. Exclusivity affects the potential value of the resource to the holder of  the  rights. Thus, exclusion ensures that the assigned specified rights may be exer- cised by the holder of the rights and not expropriated by another party. The owner can enforce his  or  her  rights  and  is  therefore  protected from any attempt by another individual to usurp the owner’s rights by unlawfully accessing the resource. Thus exclusivity increases the value of a property right. An exclusive right is not necessarily an unrestricted right to use of the resource, however. Restrictions may be imposed on the exercise of the exclusive nature of property rights. For example, equal opportunity regulations may limit the ability of the owner of real estate to restrict rental of the property to certain classes of individuals by race or gender or religion.

The third characteristic that defines a property right is the transfer- ability of the right. It is this characteristic that allows the holder of the rights to obtain returns from the resource and thus increases the value of the right. Transferability of the right to a resource may be in full, such as in a sale, or in part, such as through a lease. Restrictions may be placed on the transfer of a right. For example, inherited property may be placed in trust for an heir, the new owner. The trust may limit access of the heir to the use of the property over a period of time or indefinitely, thus limiting control rights and residual rights.

The second part of a theory of property rights delineates alternative property rights systems. A property rights system can be thought of as a configuration of control rights and residual rights. The configuration of rights is an assignment of the property rights; as noted earlier, this is established through law or tradition. There are three general configura- tions or systems of rights: private property rights, state property rights, and communal property rights. Each of these rights systems is charac- terized by the assignment of control and residual rights that carry with it variations on the characteristics of these rights

In a private property rights system, the control rights and residual rights to a resource are assigned to individuals or to organizations. For example, land may be owned (that is, rights to the land may be held) by a single person, a family, or a business or corporation. The owner may exercise control rights in the land by determining its use and alter- ations, such as through either preservation of development. The owner may also exercise residual rights to and obtain a return from the land through lease or sale of the land in either a developed or undeveloped state. The ability to exercise both the control rights and the residual rights may be mitigated by certain regulations or laws. For example, reg- ulations such as zoning laws may restrict or proscribe specific uses of the resource, altering control rights. Tax laws may affect the residual return either by increasing the return (via tax credits for either preservation or a specific form of development) or reducing the return (via a required tax on any profit or income or capital gain obtained from use of the resource).

In a state property rights system, the control and residual rights are assigned to the government, or state. This type of rights system existed in the former Soviet Union and exists at the present time in China and North Korea. Other examples of state rights assignments include US fed- eral lands, toll highways, state and municipal parks, nationalized indus- tries in some European countries, embassies, and other government buildings. State ownership is not the same thing as public ownership. In a state property rights system the  government  is  granted  exclusive rights to a resource, thereby being in the position to limit public access to the resource. For example, the government may exclude access to a military base or to federal lands where logging or other commercial activities may be either forbidden or permitted subject to specific restrictions. In this rights system the state is also granted transferability of the resource. Thus the government may sell or lease  government owned lands or the use of facilities or any natural resources contained on those lands. For example, the US federal government may lease the rights to access and sell mineral resources or trees for lumber on federal lands. Under the state property rights system, China’s system of state owned enterprises allows the central Chinese government to allocate inputs  to  these  enterprises  and  set  targets  for  output  and  profit  of the factories, following the model of the Soviet Union (He, 2002).

In a communal property rights system, control and residual rights are assigned to all members of the community. The communal property rights system is essentially one of pure public ownership. This is an open rights system, characterized by lack of exclusivity. The communal prop- erty rights system in effect grants no exclusive rights to any individual, to any organization, or to the state. For this reason, resources under the communal property rights system are common property resources. Public roads, waterways and ocean fisheries beyond the internationally agreed upon limits are examples of common property resources under a communal rights system.

The third part of a theory of property rights is the determination of the implications of rights assignments for their effects on behavior and on resource allocation, and, to a lesser degree, on income distribution. This analysis is accomplished in the context of the neoclassical model of efficient markets and assumes that wealth maximization is the objec- tive of participants in the market (Furubotn and Pejovich, 1972). In this model, any party to whom rights are assigned will exercise those rights in such a way as to increase his or her net wealth. This means that under a system of private property rights, the owner of a resource (whether an individual or an organization) will invest in the resource in a way that is consistent with neoclassical profit (residual) maximization. Thus pri- vate property rights are an important part of determining the terms of exchange. Alchian (1987, p. 1031) states it this way: ‘It probably would not be disputed that stronger private property rights are more valuable than weaker rights, that is, a seller of a good would insist on larger amounts of a good with weaker private property rights than if private property rights to the good were stronger.’ Private property rights there- fore promote resource use and exchange so that resources move to their most highly valued use. Under the private property rights  system  the total value of resources in society is maximized. That is, a private prop- erty rights system, together with individual wealth maximization in a competitive market system, promotes an  efficient  allocation  of resources in the economy (Demsetz, 1966 and 1967 and Alchian 1987). The three characteristics of a property right (clearly defined rights, exclusivity, and transferability) ensure that exchange is possible. When there are no transactions costs the exchange is feasible. As long as the exchange can be made, the efficiency of the outcome is not dependent on the initial distribution of resources,  that  is,  on  who  initially  holds the rights to the resource. Efficiency requires only that rights to the resource be assigned. It is the assignment of rights, the anticipation of the return that accompanies the rights, and the feasibility of exchange that encourages efficient allocation of resources. If there is a potential return to be made from an alternative use of a resource then the resource has value. An exchange will be made so that the rights to the resource revert to the individual or organization that anticipates the greatest return from holding the rights and therefore places the highest value on it. The distribution of income is affected by the initial assignment of rights, for this determines direction of the exchange. With no transac- tions costs, however, the efficiency of resource allocation is achieved regardless of how the rights are initially assigned (Coase, 1960).

The three characteristics of a property right (clearly defined rights, exclusivity, and transferability) also exist under a state property rights system. This may be the case either fully, as in China or the former Soviet Union, or partially, as in the United States and Europe. Where there is a state property rights system the government decides on invest- ment in state owned resources. The efficiency implications may not be the same as for a private property rights system, however. The out- come could be consistent with wealth maximization for society. This outcome would require that the government’s decision process were able to fully incorporate and reflect the interests of all members of society. Indeed, this belief was a basis for the reasoning in the establishment of the Communist Party. If, however, government either cannot or does not fully incorporate these interests than the outcome will differ from that predicted under a system of private property rights. The resulting allocation of resources under a state property rights system will be corre- spondingly less economically efficient that is, less than maximum wealth will be achieved. For this reason a system of state property rights is con- sidered to be less economically efficient than a system of private property rights. There has been considerable evidence of this, particularly in obser- vations following the movement away from such systems beginning in the 1980s and in the current movement in China from state owned enter- prises to a shareholding system (Milgrom and Roberts, 1992, Jefferson and Rawski, 1994). Even in systems of state property rights individual efficient decision behavior is possible, however, as Furubotn and Pejovich (1974b) have shown for innovation in a Soviet firm.

Under a communal property rights system, the control rights and residual rights to a resource are effectively unassigned. There are two implications for efficiency of such an open rights system. With the attending lack of exclusivity and, therefore, no right to either control or residual return, there will be minimal investment in a common property resource. This occurs because any individual or organization that invests in a communal resource is not likely to be able to appropriate the return from his or her investment. The return is likely to go to a different party who cannot be excluded but who may have made no investment.

Another implication of this type of open rights system is that com- munal property rights promote overuse of resources. Overuse results from an attempt by those who gain initial access to the resource to obtain the largest possible return before other users are able to appro- priate any share of the return. In a common property resource we observe this type of ‘first come, first serve’ self-interested behavior that is promoted by lack of exclusion. The response to communal rights assignments reduces the effective value of the resource to society, thus leading to an inefficient outcome. Behavior of this type has been observed in common property areas of ocean fisheries and other water resources, resulting in overfishing and depletion of fish that have the highest commercial value. International agreements on ocean fishing that have established limited national property rights along coastal waters has been one response to this problem. Other examples of inefficiencies due to incomplete assignment of rights include overhar- vesting of Great Lakes timber (Johnson and Libecap, 1980) and over- grazing on the western range land in the US (Libecap, 1981).

The development of property rights systems and the efficiency impli- cations of the different property rights assignments are related. Demsetz (1967) demonstrated that the decision to alter a property rights system depends on the relative benefits and costs of doing so. The process of altering a rights system includes developing new laws and traditions that are acceptable and communicating these to members of the com- munity. Altering a property rights system is therefore costly. When the value of a resource changes, this changes the value of altering a prop- erty rights system. The value of a resource may change as a result of some exogenous effect, such as increased consumer preferences and an associated increase in market demand. The higher value of the resource that may be obtained may exceed the cost of altering the rights system. If the resource value increases under conditions of a communal prop- erty rights system, then the property rights system changes. One possi- bility is that the communal property rights system will evolve to a system of state rights. This has occurred among national governments through treaties that assign coastal rights to protect ocean fisheries. Alternatively, a communal property rights system may evolve to a system of private rights, as Demsetz (1967) demonstrated with the Northwest Indians fur trading activities. Resource values may also decrease as a result of exoge- nous effects. When a resource value decreases so that enforcing private property rights becomes more costly than it is worth, the rights systems evolves into one of communal rights. An example of this can be seen in abandoned housing in urban areas where property values have signifi-cantly declined.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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