New Institutional Economics: Exploring property rights

In the last article, we had a detailed discussion on transaction costs and the challenges faced by researchers in measuring these costs. Continuing with our analysis of the various building blocks of NIE+, in this article, we will have an in-depth discussion on the concept of property rights. We will look at the theoretical and empirical aspects and the challenges therein.

Theoretical approaches

Historically, hunters and gatherers were moving all the time and hence there was no concept of property rights. This was simply because they were more concerned with food and survival from predators. After settling down along riverfronts and once agriculture and animal husbandry began, the concept of property rights began taking shape. With the coming of city-states, property rights became an important right and rights over all kinds of 'property' including slaves was protected by law. Later, as common law and civil law took root in continental Europe, property right became even more important.

In the modern democracies, property rights are protected in one form or another, either by the Constitution or by laws. The concept of property has also been expanded to include intangible things like ideas, copyright and music. It has also been expanded to include patents, which is particularly important in science and technology. One of the most visible areas where patents are seen are in the drugs and pharmaceuticals sector.

Most economists since Adam Smith and Karl Marx recognise that property rights are important for economic development, and modern mainstream economics agree with such recognition. The causation goes something like this: well-specified and well-enforced property rights provide incentives for increasing investment, innovation and trade, which leads to a more efficient market. However, different models treat the issue of property rights differently.

As per Marxian theory, property rights are linked to class struggle. As productive forces or the means of production and technology change, there is a contradiction between the existing structure (including property rights structure and ownership of means of production) and the new arrangements. This is resolved only through class struggle.

In the neoclassical model where the exchange is costless and there is full and complete information and economic actors are rational, property rights are exogenous. In other words, it is assumed that property rights are already well defined and all that is needed is to attain allocative efficiency of (other) resources. Here, the term 'property rights' has a variety of definitions, since there could be a right to ownership, right to transfer, right to income from property or right to use the property etc. However, in general, it is defined as an economic actors' right, enforced by other members of society, to use and control valuable resources. This control over resources can be by external agencies such as the government or it could be private control or it could be controlled by the community. Economic actors demand property rights since it increases the value of the resource and therefore ensures stable income streams in the present and the future and allow the resource to be used as collateral to raise funds.

In NIE, Coase was the first to put property rights at the centre of his analysis. He proposed that clearly defining and assigning property rights would resolve environmental problems by internalising externalities and relying on incentives of private owners to conserve resources for the future. In the NIE+ framework, property rights are endogenous as opposed to the neoclassical model and it is important to understand the origins of these rights and how they influence allocative efficiency. As an extension of Coase's work on property rights, the naive theory of property rights attempts to model and explain the emergence of property rights without including social and political institutions in the analysis (Eggertsson, 1990). Demsetz (1967), who proposed this naive theory stated that:

"Property rights develop to internalise externalities when the gains of internalization become larger than the costs of internalization.... the emergence of new private or state-owned property rights will be in response to changes in technology and relative prices."

Demsetz and other members of the property rights school only looked at the individual demand for property rights, ignored free-rider problems and the role of the state in supplying property rights institutions. In the tradition after Coase (1960), the analysis in these early writings also was a harmonious and optimistic one with regard to the free market's ability to develop efficient institutions. Later, other NIE social scientists filled this gap. (See Riker and Sened below).

In non-democratic countries such as the erstwhile Soviet Union or present-day China, property rights are defined and protected by the state. All the means of production, including land, are owned by the state and who gets how much property and under what conditions is also determined by the state.

Empirical research

Unlike in the case of transaction costs, there has been a fair amount of empirical research on property rights by the NIE school. This research has tended to be sectoral and accordingly property rights have been treated differently from sector to sector. Let us discuss various empirical studies on property rights.

Riker and Sened inject the role of political actors into the economic model of property rights. These political actors, backed by the state's monopoly over the use of force, determine the structure of property rights in any country. Riker and Sened assume that political actors do so rationally and grant property rights in a manner that not only enhances their own welfare but also that of the parties who have been granted this right. They analysed the evolution of property rights in time slots (the right to land and take off) at four US airports and found that these rights changed from 1969 onwards from open access to queuing to first-come-first-serve to exclusive salable rights. They suggested four conditions under which a property right may emerge: a) Scarcity of the resource; b) Demand for the property right; c) Recognition of this demand by the government and d) Respect of the right granted by the others. Riker and Sened, therefore claimed to correct Demsetz's reliance on the invisible hand of the market to supply efficient institutions.

Steven Cheung looks at how price controls change the structure of property rights. In an economy with no controls, the market allocates scarce resources through the price mechanism. However, political actors sometimes suspend the price mechanism ostensibly for 'public interest' and replace this with alternative allocative mechanisms such as rationing, lottery etc. Cheung looks at how the residential housing market in Hong Kong responded to rent control before World War II. He finds that private property rights constrain the behaviour of individuals in the market place. However, in the absence of such rights, constraints to legislative action differ from place to place and usually leads to errors in decision making. His study implies that the

existence of private property rights is a necessary condition for allocative efficiency.

Gary Libecap in a study of the evolution of mineral rights law in 19th century US found that the law evolved to reduce the uncertainty of ownership. Moreover, the main mover of the change in the law was the demand side or the mine owners, rather than the supply side or the legislators and the lawmakers. The change in the mineral rights law also suited the State Government of Nevada since it led to efficiency gains through the reduction in uncertainty of ownership. In short, the law was a response to the changes in the economic value of the mines. As the value of the mines rose, there was a greater incentive to define property rights more precisely so that the owners could realise the potential rents from the mines more fully. Further, it would also reduce the uncertainty in the ownership of the mines.

Douglass North and Barry Weingast have also suggested that economic development requires secure private and communal property rights. They argue that a ruler has to ensure a credible commitment to protect individual and physical property. This credibility comes from the reputation of the ruler. In modern democracies, it is constitutions which provide a credible commitment to secure private property. In a study of 17th century England, they find that political rules to limit the power of the Crown emerged to prevent future misuse of such power. After the Glorious Revolution of 1688, the power to affect property rights was divided between the Crown and the Parliament and this new arrangement led to a fiscal revolution and the establishment of private capital markets, which in turn were instrumental in raising resources for the various war efforts of England when needed.

Some general principles

From the above discussion on the theoretical and empirical research on property rights, we can draw some general principles on property rights.

There are various theories of property rights, but I believe that the NIE best describes the existing arrangements in most countries. As outlined above, the NIE extends the neoclassical model by injecting the role of political actors, government and courts. It does so by relaxing the neoclassical assumptions of costless transactions, perfect and complete information and perfect rationality.

Since there is no perfect rationality and since all contingencies can't be foreseen, most contracts are incomplete. Hence, a clear specification and delineation of property rights go a long way in minimising transaction costs.

Property rights arise only if the resource in question is a scarce resource and there is a demand for such a resource.

The demand for property rights arise since such a right increases the value of the resource and reduces the uncertainty and unpredictability in the ownership. This allows the right holder to use the resource in any manner she desires: whether as collateral or to sell.

Well specified property rights, which have the backing of the law or the Constitution don't arise in a vacuum but

come about because of a slow political process.

The rulers making property rights do so in a manner that they can't be changed by future rulers. The rulers agree to circumscribe their own power in the interest of predictability and efficiency, which in turn leads to better revenues for the sovereign.

Grant of property rights and maintenance of such rights is a function of the institutional structure. For example, in a communist country like the erstwhile USSR or China, property rights are granted and maintained at the behest of the state. On the other hand, in a democratic set-up, property rights are protected by a mix of formal and informal institutions and can't be easily taken away by the state.

Conclusion

We have seen above that the definition, allocation, specification and protection of property rights is an important issue for all governments. One can think of a continuum of such rights with public or state ownership being at one end and no rights or open access (in the manner of the tragedy of the commons where everything belongs to everybody and hence nobody cares for the property) at the other end. Most countries fall somewhere on the continuum. While most democratic countries protect private property rights by law or by the Constitution, socialist/communist countries have state ownership. In many countries, there is a mix of public and private ownership, with private ownership protected by law. We also saw that property rights have important attributes such as the right to use, right to enjoy income or other services, right to transfer and the right to sell the resource.

In the above discussion, we have also seen that property rights is a core concept in the New Institutional Economics+ framework (NIE+). As per this framework, well-specified and well-enforced property rights lower transaction costs by providing incentives for investment, innovation and trade and an efficient resolution of conflicts over scarce resources. Empirically, we have reviewed various studies that point to the positive correlation and perhaps even causation between property rights and economic development. Sure, there is a cost of establishing private property rights. For example in the area of environmental policy, monitoring of air, water and soil pollution is too costly at an individual level. In that sense, there are no enforceable private property rights over such public goods. In such cases, where private property rights are unavailable or too costly to establish and enforce at an individual level, the state steps in through legislation.

We will continue the discussion on the various building blocks and components of the NIE+ framework and take up other components in the coming articles.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal