Property Law Economic Theory of Property 092209 PropA

Property Law Economic Theory of Property 09/22/09 Prop_A 1

The Economic Theory of Property The law of property is closely linked to the process of resource allocation and wealth distribution in a society. Societies differ on matters relating to resource allocation and wealth distribution, implying the property law differs across societies. Individuals within our own society have very different views on property (private vs public) Nonetheless, every civil society must has a system of property law – the notion of property cannot simply be ignored 09/22/09 Prop_A 2

Four basic questions of property law: 1 How are ownership rights established? 2 What can be privately owned? 3 What may owners do with their property? 4 What are the remedies for the violation of property rights? 09/22/09 Prop_A 3

The following are some examples of the types of practical problems that arise with respect to each of these four basic questions of property law. 09/22/09 Prop_A 4

How are ownership rights established? EXAMPLE: In the early days of the Internet John begins using the address www. coke. com. As the Internet becomes better established as a commercial forum, the Coca Cola company wants to establish a website. It realizes that John is already using its most obvious address name www. coke. com to provide a bulletin board for users of illicit drugs. Can Coca Cola sue John to gain the use of the website address name? 09/22/09 Prop_A 5

John used the term ‘coke’ as part of a website address first, perhaps long before anyone could have realized that it would have commercial value to Coca Cola would like to extend it registered trade mark ownership of the ‘symbol’ COKE to its use on the Internet. The ‘rule of first possession’ implies that the first individual to use a resource has ownership. The rule of ‘tied ownership’ would say that the ownership of a website address name could be tied to the ownership of the name itself. What should we do? 09/22/09 Prop_A 6

What can be privately owned? EXAMPLE: Narrow Passage Ferry Services has been operating a ferry service between the mainland Resort Island each summer for the past 25 years. This year it finds that the Seadoo Rental Company is renting jet boats, seadoos and water ski craft for use in Narrow Passage, which is a public waterway. The resulting proliferation of recreational craft has disrupted the ferry service, making it much more hazardous, resulting in fewer trips per day and lower profits. The Narrow Passage Ferry Service sues the Seadoo Rental Company for lost profits. 09/22/09 Prop_A 7

Does the ‘rule of first possession’ apply? Narrow Passage Ferry Company was there first but it is a public waterway? Seadoo Rentals will likely argue that anyone, including its customers, should be allowed use of the waterway. Should someone own the right to use the public waterway? 09/22/09 Prop_A 8

What may owners do with their property? EXAMPLE: Hidden Glen Golf and Country Club was built in 1930, in what was then a rustic area on the outskirts of the city. Over the years, the city grew and now the club finds that the land it occupies is much more valuable as a housing subdivision than as a golf course. Local residents are upset. The course is a natural ‘green area’ and increases the value of their property. The residents successfully argue that City Council should pass a motion banning the subdivision of the property. The Golf Club sues the City demanding that it be allowed to proceed, or be fully compensated. 09/22/09 Prop_A 9

This is a dispute between the private golf club and the government. What is a private individual or group allowed to do with their property? Can a government place any restriction it finds convenient on private property use simply because it is politically expedient? 09/22/09 Prop_A 10

What are the remedies for the violation of property rights? EXAMPLE: The Greens have owned their house for over 30 years. About 20 years ago they built a stone fence across their back yard. Their backyard neighbours, the Blues, moved in about 10 years ago. Recently the Blues noticed that the Greens’ stone fence extended about six inches onto their property. The Blues’ complain to the Greens. The Greens agreed to either pay annual rental fees for the land or to simply buy the six inches of land from the Blues. 09/22/09 Prop_A 11

The Blues point out that this is trespass and sue the Greens to have them move the stone fence. This situation has existed for 10 years; why even consider it a trespass? If it is trespass, should the court force the Greens to move their fence or simply make financial compensation? 09/22/09 Prop_A 12

How would Canadian courts rule in the above cases? Fortunately, this is not a problem for us as economists We are interested in what economic theory suggests would be appropriate answers to the above questions. The above questions represent both fundamental questions in property law and interesting economic problems. (It is very easy to create interesting legal questions. It requires years of legal training and practice to develop sound legal answers. Luckily, it requires only some microeconomic theory to decide on what is an ‘efficient’ answer. ) 09/22/09 Prop_A 13

The legal concept of property Property is a ‘bundle of rights’ that describe what an individual may and may not do with the things they own (material or immaterial): ‘the extent to which they may possess, use, transform, transfer or exclude others from their property’. There are two fundamental legal rights that are essential to any notion of ownership: 1 The owner is free to exercise the rights over his/her property. No law forbids, or requires the owner to exercise the rights. 2 Others are forbidden from interfering with the owner’s exercise of her rights. 09/22/09 Prop_A 14

For example, the Forestry Company can cut down the trees they own or leave them standing. It is their decision. But environmentalists have no right to interfere in the harvesting of the trees if the Forestry Company decides to cut them down. Ownership is at times described as a ‘zone of privacy’ or as having ‘liberty over things’. The concept of property, as a ‘bundle of rights’, is very general. It is consistent with the inclusion or exclusion of a very wide range specific rights in the ‘bundle’ and also with a wide range of responsibilities imposed on the owner. 09/22/09 Prop_A 15

This ‘bundle of rights’ might change over time Consider the owner of an apartment building on Riverside Drive in Windsor, Ontario. What ‘bundle of rights’ does she possess with respect to her building? What ‘bundle of rights’ did she create for herself when she first built the building in 1965? How have these rights evolved over time and how has this affected the value of what she owns? Consider, rent controls, zoning by-laws, sign posting bylaws, parking by-laws, fire regulations, etc. 09/22/09 Prop_A 16

Why does private property exist? Is the concept of property a ‘basic - primary’ human concept? Like a parent’s care for a child, or the urge to survive? There might be some pretty deep evolutionary source for the human desire for ownership but we probably need other socio-economic theory’s to explain the existence of private property rights. Efficiency, greed, power, etc? Economist like to believe that the institutions we see around us (social institutions that have existed for a very long time) are there for a reason and that the reason is generally consistent with our notion of efficiency. Social institutions that have existed for a long time exist because they work! When they stop working they tend to disappear. 09/22/09 Prop_A 17

The origins of the institution of property: a thought experiment Consider a primitive, or initial, state of the world in which: - there are people banded together in families or tribes. - there is land, simple farm tools (sticks) and simple weapons (sticks). - no laws, courts, police or government of any sort. Each family grows crops and steals crops from other families, and attempts to protect its crops from being stolen by others. How much of each activity will each family do? 09/22/09 Prop_A 18

It depends on their productive abilities, including the quality of their tools, weapons and land. Welfare maximizing rule for individual families: Contribute resources to each activity up to the point that the marginal benefit derived from the resources in the given activity is equal to the marginal benefit of devoting the same resources to any other activity (MRTSGK, L = MRTSF K, L) It would make no sense to devote all of the family’s resources to building the most secure defence. It would make no sense to devote all of the family’s resources to growing food. Some families might specialize in (in the sense that they would tend to do more of) growing, defending or stealing. It would depend on their initial factor endowments. 09/22/09 Prop_A 19

An example Consider the allocation of labour for a given family: Current situation 10 units of labour for growing 5 units of labour for fighting MP of last unit of labour in growing = 100 units of food MP of last unit of labour in fighting = 150 units of food The above is not a food maximizing allocation of family labour. Consider the following: food available to the family Take 1 unit of labour out of growing Put the 1 unit of labour into fighting falls by 100 units increases by 150 units Net gain 50 units of food This process continues until MP of labour is equal in both activities (recall diminishing marginal returns) 09/22/09 Prop_A 20

In this world farming and fighting are rational (maximizing) activities. Is this social arrangement efficient? Maybe it is, but maybe it isn’t. The society could certainly reached a Pareto Optimum in this state. Can the society get to a ‘better’ Pareto Optimum? Can the PPF be pushed outwards? Suppose that families really only enjoy eating and that they get no innate satisfaction from stealing or defending (fighting). If we could find a mechanism which would limit the need to devote resources to fighting and thereby allow more food to be grown, families would be better off 09/22/09 Prop_A 21

A system of law which granted property rights, enforced by a government might do just that. If it requires fewer resources to agree upon a set of property rights and organize a central authority to enforce those rights, then resources would be freed up for use in agriculture. (A natural monopoly in policing might exist. ) The families would have to agree on a ‘social contract’, which would include the bundle of rights to be included in property, how the government (authority) is selected, organized and financed, etc. Such a ‘social contract’ is said to take the families from a ‘state of nature’ to a ‘civil society’ 09/22/09 Prop_A 22

To see how such a social contract might arise we need to understand when and how individuals might successfully co-operate Intro_EE_Prop and Intro_FF_Prop slide sets which introduce Game Theory and the Bargaining Model 09/22/09 Prop_A 23

In terms of a bargaining game we can think of: The ‘state of nature’, or primitive society as the noncooperative solution. The threat values associated with this non-cooperative solution are the quantities of food consumption available to each family in a world in which they must each grow, steal and protect: a world in which they cannot agree on a ‘social contract’. A social surplus, or cooperative surplus, arises from a cooperative solution in which a set of property rights is agreed upon and a government is put in place to enforce those rights (no individual family need expend resources on stealing or protecting). 09/22/09 Prop_A 24

Will there be a cooperative surplus (social surplus) from organizing a civil society? Only if it is more efficient to centralize fighting (enforcement of property rights). The society must then decide on a mechanism to share the surplus. How much each family will contribute to the cost of the government and army (a system of taxes). What is a ‘reasonable’ division of the tax burden? 09/22/09 Prop_A 25

Suppose the families currently devote resources that could grow 200 units of wheat to fighting (stealing and defending), and suppose that - it will cost resource equivalent to 50 units of wheat to negotiate an agreement among the families - it will cost the equivalent of 50 units of wheat to run the government Conclusion: if the combined cost of negotiating an agreement and enforcing it - the cost of organizing and running the government (transaction costs) is less than the current expenditure of resources on fighting, then there will be a social surplus from cooperation (organizing a civil society). 09/22/09 Prop_A 26

EXAMPLE from textbook (changed slightly) State of Nature (non-Cooperative Solution) Family Corn gained Grown (theft) Smiths 100 60 -20 140 Jones 200 20 -60 160 Total for Society 300 80 09/22/09 Corn lost (theft) -80 Prop_A Net Corn Consumed 300 27

Note that the total corn consumed equals the total corn grown. Theft simply re-distributes the corn. Now suppose that by not having to devote resources to stealing and preventing theft, the Smiths and Jones could grow an additional 200 bushels of corn (i. e. by transferring time, tools and other resources from stealing and defending to growing), use 100 bushels to organize and run the government and have 100 bushels left over. This additional 100 bushels represents the cooperative surplus. 09/22/09 Prop_A 28

Civil Society (Cooperative Solution) – assuming a ‘reasonable solution’ - 50/50 split Family Threat value Share of surplus Net corn consumed Smiths 140 50 190 Jones 160 50 210 Total for Society 300 100 400 09/22/09 Prop_A 29

Note The threat values are determined by the ‘state of nature’ even if the ‘reasonable solution’ applies, the income distribution is not uniform after a ‘civil society’ is introduced. All of this will only work if the cost of introducing a government is less than 200 bushels of corn (recall they will need to pay for the government) Is this really how property rights originated? I don’t know. Economist do not like institutional explanations for anything! 09/22/09 Prop_A 30

Would Alberta or Quebec be more believable if they threatened to secede from Canada? What if the United States invited Alberta to become the 51 st state? QUESTION: Can we interpret the ending of the Cold War and the resulting ‘peace dividend’ as the outcome of a cooperative solution among nations? 09/22/09 Prop_A 31

We do know that there is a strong tendency for modern society to avoid chaos and to try to establish property rights. We do know that property rights evolve over time – is part of the reason for this change that the threat values of individual groups change over time? Maybe property rights are a form of technical change. This is really just a more ‘dynamic’ notion of efficiency in that a new social arrangement must be developed as threat values change. We can think of a set of enforceable property laws as a kind of technology. As an historical process, the development of property rights is an evolutionary process. 09/22/09 Prop_A 32

It might have began with a few rudimentary agreements among marauding bands of primitives, but it has continued on through the centuries and continues today. Ownership of land has been long established. But what about the right to fish certain waters? The right to oil or gas resources which flow under land owned by many owners? The right to use a certain segment of the radio frequency, television frequency, cellular telephone frequency? The right to a particular name for an Internet address? These items, along with inventions, brand names, songs, poems, books, computer software, new forms of life and many other unique forms of property require an evolving and growing body of property law. 09/22/09 Prop_A 33

COMMENT: In a modern society this ‘social contract’ and related system of private property rights is fairly complex. It has developed slowly over hundreds of years. Consider the former Soviet Union How quickly can a society which was more or less a feudal society under the Tsars, and had very limited private property rights under Communism, create a set of enforceable private property rights? The exercise which the former Soviet Union is undertaking is much more complex than our simple thought experiment applied to a primitive society. Why bother? Because, the payoffs are enormous. 09/22/09 Prop_A 34

What comes first: organized society (the law) or property rights Example in notes There are four groups (families) of criminals, each of which supplies illegal goods and services (drugs, gambling, prostitution, etc. ) throughout Canada. Each gains revenue from supplying these goods and each steals from other crime families whenever possible (after all who is going to complain to the police). As a result each family must spend resources (family members’ time, bullets, etc. ) in protecting its operation from other criminals. Is there a better solution? See on of the examples in Lecture notes Econ 230 bii. pdf 09/22/09 Prop_A 35