BSM940-Lecture6-Foundations of Market Economy(1)

8/12/2019 BSM940-Lecture6-Foundations of Market Economy(1)

1/19

BSM940

Economic Environment of Business

Lecture 6

Property rights and contracts

Prof. Tomasz Mickiewicz

Aston Business School, Economics & Strategy


2/19

Private property rights

Private property rights establish a

relationshipbetween defined individualsand defined assets, which can be physicalgoods, ideas or people own bodies.

Free use of property is limited only by therights of others. In case of damage, onus

of proof lies with the claimantthis isimportant because proving the claim isan important material constraint onexcessive limitations of free property use.

Uncertainty among investors about the

security of their property rights in theircapital and its prospective returns maylead to underinvestment, capital flightand poor economic performance.

2


3/19

Special types of property:

intellectual property, self-ownership

Property rights can also be attached toidentifiable bits of knowledge.Producing knowledge is a riskyundertaking and people will engage init if the owners of valuable knowledgewill be allowed to reap materialbenefits from sharing it with others.

Slaveryis seen as a violation as a basichuman right to self-ownership.

But self-ownership also applies to theright to use own skills and efforts tothe best benefit.

Restrictions on movement of people,compulsory union membership and

minimum wages are all violations ofthis basic right. 3


4/19

Excludability

Excludability is the definingcharacteristics of property rights. Itmeans that others can be excludednot only from the benefits of anasset, but also that the owners areexclusively responsiblefor thecosts of assets uses, as well as thecosts of ensuring exclusion.

Excludability is important inensuring that private propertyuses are steered to reflect whatothers want. The incentive todeliver what other want worksthrough the profit-loss signals.

4


5/19


6/19

Coase versus Pigou

Pigou (1930s): the problem of externalities should be solvedby the government taxingthose property uses that causeexternal costs and subsidizinguses that cause externalbenefits, as well as compensating those bore the impact ofexternal costs.

The assumption is that government officials: can assess the costs and benefits, and

will have incentives to implement optimum solution

Coase (1960) demonstrated that taxes and subsidies are not

necessary to remedy the problem of externalities. Thosewho caused external costs and those who were impactedcould get together to bargain and exchange property rights,provided transactions cost were not too high.

6


7/19

Coase Theorem and efficiency of law

Coase theorem:

If rights are well-defined and transferable and if transactions

costs are not too large, then the initial distribution of propertyrights is irrelevant for achieving efficiency, because parties can

enter into free exchange and the rights will move to their

highest value in use.

Thus, efficient design of the legal environment implies a structure

of law that makes transaction costs low in order to facilitate

exchange of rights, which in turn maximises value. 7


8/19

8

Source: Kasper, Streit, Boettke

F o r m s o f P r o p e r t y


9/19

Exclusion costs

Exclusion costs are incurred when owners employ resources to

exclude others from owning or using their property. High exclusion costs lower the value of property. They depend

on institutional arrangements, beginning with underlyingstandards of ethics that are shared in the community.

Differences in institutional systems have great influence on

exclusion costs and therefore property values. Propertyowners, when they have a chance, shift their property toenvironment where it is well protected and hence highlyvalued.

In many developing countries people enjoy little effective

protection of their property: they are frequently subject torackets and excessive regulations; many experience theproperty risks of war and civil conflicts.

In contrast, when exclusion costs are reduced, people find itmore attractive to acquire and activate property, thereby

helping themselves out of their poverty. 9


10/19

Question

For 5 minutes, pleasediscuss with the personnext to you

Please find examples ofproducts and servicesaround you with (a) low,and (b) high exclusion

costs. What could be done

about it?


11/19

Exclusion costs: follow up

When property rights are ill defined and poorly protected by

legal means, people may try to define and protect them forthemselves. This is the origin of protection rackets by theMafia and self-help organizations (vigilantes), which take thelaw into their own hands.

The danger however is that those self-appointed violence

professionals: use their means of coercion to extract high prices for the

protection, or that

rival gangs fight over the clientele of property owners, causingcollateral damage among innocents.

In such a situation, collective, law-bound government can offergreat reduction in exclusion cost to property owners.

Respect for private property is low where wealth distribution iswidely perceived as unjust (e.g. originated with oppressivepolitics, like in much of Latin America or Africa or grabbing of

former state property by oligarchy like in Russia). 11


12/19

Divisibility and Transferability

Divisibilitymeans that property rights can be unbundled.In particular, core (passive) ownership rights can beseparated from rights to specific uses of an asset, forexample:

The title to a lake being separated from the right to fish in

the lake or the right to swim in it, Those who have the title to a forest assign differentiated

right to hunt, to go for walks and invest in tree growing

Ownership in a company is divided into shares.

Property should be disposable(transferable): the owners

retain the right to transfer the ownership, for examplethrough sale, inheritance or donation.

When property is tied to the owner that prevents otherswho may value the property more highly (because of theirbetter knowledge and skills) from making better use of it.

12


13/19

Transactions costs of using property rights in

economic cooperation Property rights are used in exchange via voluntary contracts which establish a

binding agreement to:

a) Pay an agreed price,

b) To hand over property rights as agreed.

If (a) and (b) occurs simultaneouslythe transaction costs are low, however this

relates only to simplest forms of exchange. If (a) and (b) are separated over time, contracts have to include provisions for

credible commitments that the obligations will indeed be fulfilled. Sanctions haveto be provided against opportunistic non-fulfilment, and provisions need to bemade for sorting out subsequent misunderstandings or disagreements.

Creating credible commitments is a key problem of cooperation, for example: Hostages can be used, where contracts are protected by the other party

having a special claim on specified asset in case of non-fulfilment (e.g.mortgage)

Intermediaries who have a reputation to lose (e.g. banks) join contractingparties (e.g. savers and investors) as a middleman who offer more credible

safeguards. 13


14/19

Open-ended, relational contracts In relational contracts not all eventualities can be foreseen,

let alone regulated by contract provisions.

A typical example is an employment contract.

Given uncertainty and the costs of drafting and negotiating,the contract can never enumerate and regulate all aspects

of the deal, in particular if it extends over a long period oftime.

Thus, contracts have to rely on universal, abstractinstitutions within which specific eventualities can besettled in reasonably predictable ways. General legal

principles such as acting in good faith or dead is a dealare rules that enhance trust in contract.

In contrast, simpler, non-relational contracts can bestandardized, saving on knowledge, negotiation andenforcement costs (e.g. letting agreement).

14


15/19

Transaction costs of market contracts

versus organisation costs of firms Transaction costs are coordination costs that are

incurred when property rights are exchanged in markettransactions. They consist of:

Information search costs (to find a sufficient number of

exchange partners, their location, product design, quality,reliability)fixed, sunk costs of transactions

Costs of negotiating, concluding and monitoring thecontract

Costs of adaptationre-negotiating contracts when

conditions change, and cost of possibly dealing withcontract breaches (recurrent costs of transaction).

In some occasions coordination costs of markettransactions are higher than organization costs ofentering into open-ended, semi-permanent

hierarchical arrangements that are called firms. 15

Ex

ante

Ex

post


16/19

Relational contracts: self-enforcement

In advanced market economies, many property uses are

based on contractual relationships, which depend as muchon self-enforcement mechanismsas on reliable externalenforcement.

a) Profitable businesses relations extend over a long time. In

such cases tit-for-tat responses can be a powerfulsanction. Also, in well identified trading communities,sanctions may take the form of exclusion of offendingparties from future trade (ostracism). Merchant habitsand virtues develop over time reducing transaction costs.

b) Credibility of commitments in enhanced when there aregains from building a reputation. This works in tradingcommunities when information is communicated andsome basic values (that define reputation) are shared.

16


17/19

Relational contracts, self-enforcement

and the judiciary - morec) Self enforcement is enhanced by the introduction of third

parties (intermediaries). For example, these can act asguarantors.

d) Prior agreement on an adjudicator: an independentperson or organisation asked to look into a conflict and togive a verdict. A stronger form is compulsory arbitration, acontract provision that binds the parties to accept theverdict in case of dispute.

e) Contact enforcement may depend on a third party whoenters as a directly involved intermediary: themiddleman., who conduct back-to-back transactions ontheir own account. Apart form helping with informationsearch, they fulfil the important role of offering trust incontract fulfilment.

17


18/19

Readings

For this lecture

please read Kasper

et al., chapter 7.


19/19

Topic for tutorials: decentralisation

Second Round Readings:

Jean-Francois Hennart (1993). Explaining the Swollen Middle: Why Most

Transactions Are a Mix of "Market" and "Hierarchy. Organization

Science. Vol. 4, No. 4, pp. 529-547.

Robert S. Kaplan (1984) The Evolution of Management Accounting. TheAccounting Review, Vol. 59, No. 3, pp. 390-418.
http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://course.lixin.edu.cn/course_center/files_upload/jpkc/guanlikuaiji/COLUMN_16/file3/09.pdfhttp://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955http://arno.uvt.nl/show.cgi?fid=44955

BSM940-Lecture6-Foundations of Market Economy(1)

Documents

Transcript of BSM940-Lecture6-Foundations of Market Economy(1)