We begin our discussion by reviewing reasons why property rights should exist and by describing instances of their emergence. Then we consider the major questions addressed by property law: the division and form of property rights, public property, the acquisition and transfer of property, and conflicts in the use of property (externalities). Last, we examine the subject of intellectual property. Many of the topics in this section have not been formally analyzed.
Justifications for Property Rights
A time-honored and fundamental question is why should there be any property rights in things.30 That is, in what respects does the protection of property and the ability to transfer property promote social welfare? One justification for the protection of property is that it furnishes incentives to work, a common example being that people would not grow crops unless they could keep the product of their labor. Similarly, property rights provide incentives to maintain and improve durable things: repair buildings, to fertilize and irrigate land, to conserve renewable resource stocks.31
Another justification for property rights is that, were they absent, individuals would spend time and effort trying to take things from each other and protecting things in their possession, and they would often find themselves involved in conflict. Enforcement of property rights by the state, while involving its own costs, reduces these serious disadvantages that would be incurred in the absence of property rights. A related benefit of enforcing property rights is that it protects people against risk.In addition, it is important that a system of property rights allows for things to be transferred freely. Most obviously, if things can be traded, they will tend to be allocated to those who value them most.32 Moreover, the ability to transfer things is indirectly necessary to our enjoyment of economies of mass production and specialization of labor, for when a large quantity of a good is produced by a single entity, the output ultimately will have to be distributed, which is to say, transferred, to many other individuals, and the entity will also often need to obtain inputs from other parties. In addition, transferability of property (particularly of land) allows it to be used effectively as collateral, thus enabling credit markets to function.33
30A related question concerns how such rights should be protected. See Calabresi and Melamed (1972) and Kaplow and Shavell (1996a).
31Problems with conserving renewable resources that arise in the absence of property rights are often referred to as the tragedy of the commons. See Gordon (1954), Hardin (1968), Libecap (1998), and Ostrom (1998).
32We also note that protecting the security of property rights promotes the transfer of property: without protection of property rights, prospective buyers would not be inclined to buy things that might subsequently be stolen, and prospective sellers would be wary of making their ownership of valuable possessions known to others.
33Empirically-oriented literature on the various benefits of property rights includes Alston, Libecap, and Schneider (1996), Atwood (1990), Besley (1995, 1998), and Feder and Feeny (1991). Early writing about property rights — by Bentham (1830), Blackstone (1765-1769), and Hobbes (1651), among others — stressed the justifications involving incentives to work and avoidance of strife.
can be provided by paying workers on the basis of effort, even if a state enterprise owns what they produce. (Indeed, employees of profit-maximizing firms in private-enterprise economies are generally motivated by pay rather than by the literal ability to sell what they produce.) And the benefits of avoiding strife and theft might be enjoyed just as much under a centrally planned economy as under a market economy. The arguments for the social value of the marketenterprise system over central planning are different from those justifying the existence of property rights per se. (The arguments favoring market systems are based largely on the informational burdens that central planners face, problems of corruption, and the like.)
3.2. Emergence of Property Rights
We would expect property rights to emerge from a background of no rights or only poorly established rights when the various advantages of their existence substantially outweigh the costs of establishing and maintaining the rights.34 Property rights will be likely to arise in these circumstances because, if many individuals recognize that they will probably be better off under a regime with property rights, pressures will be brought to bear to develop them. Various examples of the emergence of property rights have been studied. Umbeck (1981) examines property rights during the California Gold Rush. When gold was discovered in California in 1848, property rights in land and minerals were largely undetermined and there were virtually no authorities to enforce the law. Almost immediately, however, arrangements were made to protect property rights in gold-bearing land and river beds. This encouraged individuals
to pan for gold, to build sluices, and otherwise to invest to extract gold; it also curbed wasteful efforts to grab land and gold from one another.
An additional example of historical interest is the establishment by the Indians of the Labrador Peninsula of rights in land where none had existed. Demsetz (1967) connects this 17th century event to the increased value of furs. He suggests that without property rights in land, overly intensive hunting of fur-bearing animals (especially beaver) would have taken place and the stock of animals would have been depleted.
We note that property rights can be established and enforced by the state or informally, through social norms. On the latter, see Ellickson (1989, 1991) and Sethi and Somanathan (1996). Property rights also might be enforced by private organizations, such as the Sicilian mafia. See Gambetta (1993).
A more recent instance of the emergence of property rights concerns resources of the sea, as described in Biblowit (1991) and Eckert (1979). For most of history, there were no property rights in the ocean’s fisheries because fish were in inexhaustible supply for all practical purposes, but fish populations have come under strain with the use of modern fishing methods. To provide incentives to preserve fisheries, it has come to be accepted that countries have property rights in fish found in their coastal waters. Also, property rights have recently been established in the sea bed to foster exploration and extraction of oil and mineral resources. Another important example of the appearance of property rights concerns rights to the electromagnetic spectrum; assignment
of these rights prevents garbling of signals and encourages investment in programming and transmission as well as trade of rights to high-value users. See DeVany, et al. (1969) and McMillan (1994).35
3.3. Division and Form of Property Rights
3.3.1. Division of property rights. From a conceptual viewpoint, what we speak of somewhat loosely as property rights can be divided into more basic rights, composed of particular possessory rights and rights to transfer these rights. A possessory right in a thing is the right to use it in a specified way at a named time and under a particular contingency. A right to transfer a possessory right is the right to give or sell a possessory right to another person. Thus, what we commonly conceive of as “ownership” of something (say, land) entails both a large swath of possessory rights (rights to build on land, plant on it, and so forth, under most contingencies, and into the infinite future) and associated rights to transfer them.
In fact, property rights in things are generally held in substantially agglomerated bundles, but there is also significant partitioning of rights contemporaneously, according to time and contingency, and according to whether the rights are possessory or are for transfer.
For example, an owner of land may not hold complete possessory rights, in that others may possess an easement giving them the right of passage upon his land, or the right to take timber, or the right to extract oil if found (thus a contingent right). A rental agreement constitutes a division of property rights over time; wills provide for future and often contingent division of rights (depending on the survival of beneficiaries). Trust arrangements, such as those under which an adult manages property for a child, divide possessory rights and rights to transfer.
35Literature on the emergence of property rights is surveyed in a general discussion of property rights and economic activity in Libecap (1986).
The division of possessory rights may be valuable when different parties derive different benefits from them, because gains can then be achieved if rights are allocated to those who obtain the most from them. There are, however, several disadvantages to the division of possessory rights or too fine a division of the rights. Individuals may wish to exercise the same rights at the same time (a person with a right of passage may wish to use a path that is currently blocked by the owner’s use); externalities and related conflicts may arise (a person with a right of passage might trample crops). In addition, logistical problems may impede the division of rights (consider the problem of many individuals trying to share the use of a single automobile).
3.3.2. Consolidated form of property rights and the theory of the firm. Ownership of separate productive assets is often consolidated; namely, it is held by a single entity, the firm. The question of what constitutes the benefits of this form of ownership was initially posed by Coase (1937) and has subsequently been developed by, among others, Williamson (1975, 1985), Klein, Crawford, and Alchian (1978), Grossman and Hart (1986), and Hart (1995).36 Here, we review the main factors that bear upon the relative advantages of separate versus consolidated holding of assets by firms.37
First, consolidated ownership of assets reduces transaction costs because internal transfers of goods and services may be accomplished by command, eliminating the need for negotiation and bookkeeping expense.38 Such reduction of transaction costs, however, often could be obtained as nwell by separate owners if they entered into long-term supply contracts, honored standing orders, and the like.
Second, consolidated ownership may lead to a dilution of incentives to work, in comparison to the situation where each individual owns the assets he uses in production. Firms can combat this incentive problem in two familiar ways: if they can observe individuals’ efforts, they can penalize shirking; if not, they can tie compensation to measures of output.39 Of course, both methods have costs. (Interestingly, the latter may re-introduce transactions costs, such as if transfer pricing is required to compute a manager’s contribution to the firm’s profits.)
36See also Alchian and Demsetz (1972), Hart (1989), Hart and Moore (1990), Holmstrom and Tirole (1989), and Jensen and Meckling (1976). For a discussion of different forms of consolidated ownership (including employee-owned firms, cooperatives, and nonprofits), see Hansmann (1996).
37The subject of consolidated versus separate ownership of productive assets could be viewed as falling under the heading of division of property rights (separate ownership being division of consolidated ownership), but we find distinguishing the two subjects helpful.
38This savings may involve some sacrifice. For example, information on the profitability of separate functions may be lost (unless there is internal transfer pricing, which may involve transaction costs similar to those of market exchange).
39Ellickson (1993), among others, suggests that most communal farming efforts have failed because individual rewards were not linked to effort or output, which led to widespread shirking. It may be observed as well that modern firms succeed despite their often large size through monitoring of workers’ behavior (which may be more feasible with the use of mechanized technology) and use of performance pay.
Third, consolidated ownership enables a firm to avoid breakdowns in bargaining that would occur under separate ownership due to asymmetric information. For example, under separate ownership, the seller of a factor input might overestimate its value to the next-stage producer and demand too much for it, stymieing an efficient transfer. Under consolidated ownership, efficient transfers can be ordered.40 Alternatively, however, separate owners could contract in advance for transfers to occur at a predetermined price.
Fourth, consolidated ownership may help to alleviate problems of inadequate investment in assets. An asset owner may not have a sufficient incentive to make a relationship-specific investment (upgrading a plant for producing a factor input) because he anticipates that his gains will be partially expropriated by the owner of a complementary asset at the time when he is to put his asset to use. But if both assets are owned by the same party, the problem of expropriation of the gains from the relationship-specific investment in the first asset will be mitigated, and investment in it should be more efficient. However, the other individual’s incentive to invest in what otherwise would have been his asset may be dulled if the first party owns both assets; thus, consolidated ownership does not necessarily improve investment incentives overall. Additionally, it may sometimes be possible under separate ownership of assets to guarantee that investments in them be sufficient by making a contract to that effect; but this requires that investments be observable.
We close by noting that the distinction between consolidated ownership of assets by firms and separate ownership is blurred because, as we have mentioned, under separate ownership together with contractual arrangements, it is often possible to replicate the advantages of firms.
Indeed, separate ownership combined with sufficiently encompassing contracts may be indistinguishable from the consolidation of ownership of assets by firms. Conversely, firms themselves can be understood to consist of a set of contracts (a corporation is a particular contract among its shareholders).
The manager might know that the transfer is efficient without knowing the precise cost and/or value of the factor input, for the cost distribution may be below the value distribution. When distributions are, instead, substantially overlapping, a manager will not know whether a transfer is efficient, and in this case bargaining between separate parties may well promote efficiency.
3.4. Public Property
Before continuing with our analysis of property rights, we consider briefly an important class of property, that owned by the public. We review the justifications for public property and then two methods of acquisition of such property: by purchase and by unilateral public taking.
3.4.1. Justifications for public property.
The main justifications for public property concern problems with private supply. The government builds and maintains roads, for example, because private supply often would not be forthcoming due to difficulties that would be faced in collecting for road use. And even if roads were privately supplied, suppliers would charge tolls, raising problems of monopoly pricing and wasteful expenditures on toll-collecting. Problems with private supply, however, do not constitute an argument for public ownership of goods, only for public financing of them or for public regulation of private suppliers. A road could be constructed, maintained, and owned by a private party paid by the state. And when private ownership might involve problems of monopoly pricing, government regulation is an alternative to direct ownership. These observations underlie the growing attention to privatization of public property and of government activities. The comparative virtues of public versus private ownership depend on the relative abilities of the government and of the private sector to operate efficiently and maintain quality.41
3.4.2. Acquisition of public property: purchase versus compensated takings. The state may acquire property through purchase or through exercise of the state’s power of eminent domain, which is to say, by taking the property. In the latter case, the law typically provides that the state must compensate property owners for the value of what has been taken from them, and it will be assumed that this is the case until the next section.
The difference between purchases and compensated takings is that the amount owners receive is determined by negotiation in the former case but unilaterally by the state in the latter case. Because of possible errors in governmental determinations as well as concerns about the behavior of government officials, purchase would ordinarily be superior to compensated takings.
An exception, however, arises where the state needs to assemble many contiguous parcels, such as for a road. Here, acquisition by purchases might be delayed or prevented by hold-out problems, making the power to take advantageous.
41See, for example, Hart et al. (1997), Shleifer (1998), and Viscusi et al. (1995, pp. 468-70)
3.4.3. Compensation for takings. Assuming that there is a reason for the state to take property, consider the effects and desirability of a requirement that the state pay compensation to property holders. As emphasized by Blume et al. (1984), payment of compensation to property owners creates a potential moral hazard: it leads them to invest excessively in property.
A second effect of compensation for takings is that risk-averse property owners will bear less risk.42 But were takings not compensated, insurance against takings would be likely to emerge.
Moreover, private insurance would naturally alleviate the problem of excessive investment in property.43
Third, payment of compensation also may alter the incentives of public authorities to take property by reducing possible problems of overzealousness and abuse of authority. However, requiring compensation may also exacerbate potential problems of too little public activity (public authorities do not directly receive the benefits of takings). Therefore, it is not clear whether a compensation requirement would improve the incentives of public authorities. For further discussion of these various issues about compensation for takings, see Kaplow (1986a, 1992a).44
3.5. Acquisition and Transfer of Property
We return now to the subject of private property and consider a number of topics relating to its acquisition and its transfer.
3.5.1. Acquisition of unowned property. Wild animals and fish, long lost treasure, certain mineral and oil deposits, and, historically, unclaimed land, constitute primary examples of unowned property that individuals may acquire. The law has to determine under what conditions a person will become a legal owner of such previously unowned property, and a general legal rule is that anyone who finds, or takes into his possession, unowned property becomes its owner. Under this finders-keepers rule, incentives to invest in capture (such as to hunt for animals or explore for oil) are optimal if only one person is making the effort. However, if, as is typical, many individuals seek unowned property, they will invest socially excessively in search: for one person’s investment or effort usually will not simply increase the total probability of success, but rather will come at least partly at the expense of other persons’ likelihood of finding unownedn property.
It should be noted, however, that many property owners — namely, firms with diversified ownership — are not very risk averse.
43Notably, insurance premiums would be based on the value of property, so further investments would raise premiums.
44On the topic of compensation for loss in value of property due to regulation (as opposed to the physical taking of property), see Fischel (1995) and Miceli and Segerson (1996).
This problem is similar to the tragedy of the commons. See Gordon (1954) and Hardin (1968).
Various aspects of the law governing the acquisition of property may be regarded as ameliorating this problem of excessive search effort under the finders-keepers rule.46 Notable examples are that regulations may limit the quantities that can be taken of fish and wild animals, the right to search for oil and minerals on the ocean floor may auctioned off, and oil extraction may be “unitized” (assigned to one party).47
3.5.2. Loss and recovery of property. When property is lost by its owner and is found by another person, the question arises whether the original owner should retain property rights or the finders-keepers rule should apply. The general stance of the law is that original owners maintain their property rights in lost things (unless they abandon them). This beneficially discourages original owners from socially excessive investment in preventing losses: a farmer might otherwise invest in an expensive fence to prevent his cattle from straying, which might be inefficient because often his private loss would not constitute a social loss (someone would be likely to find the strays).
Moreover, original owners usually can either search themselves or efficiently organize recovery efforts by others (including by offering rewards). If, however, original owners cannot do this, the finders-keepers rule does have the advantage of inducing recovery effort, even though the rule tends to encourage races to find the effectively unowned property.
3.5.3. Acquisition of stolen property and problems of establishing valid title. A basic difficulty associated with sale of property that a legal system must solve is establishing validity of ownership or “title.” How does the buyer know whether the seller has good title, and how does the buyer obtain good title? If these questions are not readily answered, sales transactions are impeded, and theft may be encouraged.
One route that legal systems may take involves the use of registration systems: lists of items and their owners. Important examples are registries of land, ships, motor vehicles, and many financial instruments. Presuming that an item is recorded in a registry, it will be easy for a buyer to check whether the seller holds good title to it, and the buyer will obtain title by having his name recorded in the registry as the new owner. a general deterrent against theft. (An individual contemplating registration will not take into account that, as the proportion of registered property rises, thieves anticipate that it will be more difficult to sell stolen property and thus are discouraged from theft.)
46For a survey of relevant literature, see Lueck (1998).
47Other laws limit indirectly how much property can be taken by individuals by giving them title only if they make productive use of the property that they find. This was true of homestead laws that gave land to individuals who worked it
and of water rights regimes that gave priority to the extent that water supplies were regularly used. Such rules, however, create excessive incentives to exploit property. For most goods, however, registries do not exist because of the expense of establishing and maintaining them relative to the value of the goods and of the deterrence of theft.
These rules have different effects on incentives for theft. Notably, under the bona fide purchaser rule, theft is made attractive because thieves will often be able to sell their property to buyers (who will be motivated to “believe” that the sale is bona fide); the buyers can use the now validly-held property or resell it.
Another social cost of the bona fide purchaser rule is that original owners will spend more to protect their property against theft because theft will be more frequent and, when it occurs, owners will be less likely to recover their property. (These costs of protection, note, are analogous to those arising under the rule allowing finders of lost property to keep it.) Finally, under the bona fide purchaser rule, buyers will not have an incentive to expend effort determining whether there exists a third party original owner. This is an advantage in the direct sense that it reduces transaction costs, but it also compromises deterrence of theft.
3.5.4. Involuntary transfer of property: adverse possession. The legal doctrine of adverse possession effectively allows involuntary transfer of land (and some other types of property): a person who is not the owner of land becomes its legal owner if he takes possession of it and uses it openly and continuously for at least a prescribed period, such as ten years. Some have suggested that a rationale for the rule is that it permits the transfer of land from those who would leave it idle to those who will use it productively. But this overlooks the possibility that there may be good reasons for allowing land to remain idle (perhaps it will be built upon later, and thus an investment in it now would be a waste). A historical justification for the rule is that, before reliable land registries existed, it allowed a landowner to establish good title to a buyer relatively easily: the seller need only show that he was on the land for the prescribed period. Another advantage of the rule is that it reduces disputes that would arise where structures turn out to encroach on neighboring parcels.48
3.5.5. Constraints on sale of property. Legal restrictions are often imposed on the sale of goods and services, including taxation and the outright banning of sale. One standard justification for such policies is externalities. See section 3.6. The other standard justification for legal restrictions on sale is lack of consumer information. For instance, a drug may not be sold without a prescription because of fear that buyers would not use it appropriately. Here, though, one must compare the alternative of the government supplying relevant information to consumers (say that the drug has dangerous side effects, or that it should only be taken with the advice of a medical expert).
On adverse possession, see Netter (1998).
49For further discussion, see section 4.1.9 on legal overriding of contracts
3.5.6. Gifts. The making of gifts, including bequests, is the major way in which property changes hands other than by sale. Gifts are, as one would expect, rather freely permitted because, like sales, they typically make both parties better off.50 It should be observed that, in the absence of a state subsidy, the level of giving may well fall short of the socially optimal level because a donor’s private incentive to make a gift does not take into full account the donee’s benefit. See
Kaplow (1995b).51 In addition, some gifts, particularly to charities, may support public goods or accomplish redistribution, which may provide a further ground for subsidy.52 In fact, the law does favor certain types of giving by conferring tax advantages on donees (and, in the case of charities, on donors). On the other hand, heavy gift and estate taxes are levied on large donative transfers to individuals. Another issue concerning gifts is that a person may want to make a transfer in the future, in which case issues concerning contracts to give gifts arise. This subject will be discussed below in section 4.3.2 on donative contracts.
3.6. Conflicts in the Use of Property: Externalities
3.6.1. Socially optimal resolution of externalities. When individuals use property, they may cause externalities, namely, harm or benefit to others. As a general matter, it is socially desirable for individuals to do more than is in their self-interest to reduce detrimental externalities and to increase beneficial externalities.
It should be noted, as emphasized by Coase (1960), that the socially optimal resolution of harmful externalities often involves the behavior of victims as well as that of injurers (and similarly with regard to generators of positive externalities and beneficiaries). Where victims can do things to reduce the amount of harm (install air conditioning to avoid pollution) more cheaply than injurers, it is optimal for victims to do so. Moreover, victims can sometimes alter their locations to reduce their exposure to harm. When the latter possibility is not incorporated into the analysis of externalities (suppose that victims are assumed to continue to live adjacent to a hazardous waste site), what is referred to as the optimal resolution of externalities may only be conditionally optimal.
3.6.2. Resolution of externalities through state intervention. We now consider various means of government intervention, along the lines of Shavell (1984a, 1984c, 1993a).53 For convenience, we confine our attention to the case of harmful externalities, and we will assume (until the next section) that parties affected by externalities cannot bargain with the generators of externalities.
See also Friedman (1988) on the gift externality.
See, for example, Atkinson (1976) on redistribution and charitable contributions.
See also Bovenberg and Goulder (forthcoming, chapter __ of this Handbook) on environmental taxation.
Under direct regulation, the state restricts permissible behavior. It might impose a quantity constraint (a fisherman may be required to limit his catch to alleviate depletion of the fishery) or other behavioral constraints (a factory may be required to use a smoke scrubber). Closely related to state regulation is privately-initiated regulation through use of the legal injunction, whereby a
potential victim can enlist the power of the state to force a potential injurer to take steps to prevent harm or to cease his activity.
Society can also make use of financial incentives to induce injurers to reduce harmful externalities. Under the Pigouvian tax, a party pays the state an amount equal to the expected 50There are some limits on disinheriting one’s immediate family and other rules that prevent individuals from controlling the use of their gifts long into the future (the rationale for which is not entirely clear).
An additional type of financial incentive is a subsidy, an amount paid by the state to a party equal to the reduction in expected harm from some benchmark level that he accomplishes.
There is also liability — a privately-initiated means of providing financial incentives — as we discussed in section 2. Under strict liability, a party who causes harm has to pay the victim for his losses. (Such liability differs from the corrective tax because payment is to the victim rather than to the state, and also because injurers pay for actual harm rather than for expected harm.) Under the negligence rule, an injurer must pay the victim only if the injurer failed to take a cost-effective precaution.
In fact, liability and regulation are the preeminent tools that society uses to control externalities; the use of corrective taxes and subsidies is unusual. Since Pigou (1932), who first emphasized the problem of externalities, economists have focused on corrective taxes and regulation, essentially ignoring liability. We will now sketch some factors bearing on the relative desirability of these methods of controlling externalities. The review of factors will show that any of the methods (or a combination) could be the best, depending on the context.
One factor of relevance is the quality of the state’s information. If the state has complete information about acts, that is, it knows the injurer’s benefit or cost of precautions along with the victim’s harm, then all of the approaches allow achievement of optimality. But if the state’s information is imperfect, it will not be able to calculate which actions (such as installing a smoke scrubber) are desirable and thus sometimes will err. However, if the state knows the expected harm, it can induce injurers to act optimally under the corrective tax or a rule of strict liability because the injurer, who is presumed to know the cost of a precaution, will then appropriately balance the cost against the reduction in expected harm that would be brought about.
This advantage, as it applies to the comparison between strict liability and the injunction, is suggested by Calabresi and Melamed (1972) and is further explored in Kaplow and Shavell (1996a) and Polinsky (1980b).
We emphasize that this basic informational argument favoring Pigouvian taxes or strict liability over regulation or the negligence rule extends to the case where the state is uncertain about the magnitude of harm. The reason, essentially, is that under the former rules, the state only needs to estimate expected harm (as the injurers themselves implicitly supply complete information about the costs of precaution when making their decisions). By contrast, under regulation and the negligence rule the state must estimate both expected harm and precaution costs. Because the state’s effectively available information is strictly better under the corrective tax or strict liability, it can achieve a superior outcome. (This point holds notwithstanding Weitzman’s argument suggesting that quantity regulation may be superior to corrective taxation.55) An implication is that the use of pollution taxes is superior to the use of tradeable pollution permits because, under the latter, the government sets the total quantity of pollution using its own estimate of abatement costs rather than implicitly relying on firms’ information.56
A second factor is the information available to victims. For many externalities, victims have better information than the state about who is causing harm or about its extent — because they actually suffer the harm — so they are the most appropriate enforcement agents, suggesting the desirability of the liability tool or the injunction. In other instances, however, victims may be unaware of the harm or its cause, making the state a better enforcer. State enforcement, such as by regulation or by corrective taxes based upon statistical evidence of expected harm, avoids the need to identify, say, which pollutants ultimately harmed which victims.
A third factor concerns the level of activity of an injurer (how much a firm produces, how many miles a person drives), as opposed to the precautions an injurer takes given the level of activity (whether a firm uses a smoke scrubber while producing, whether a person exercises care when driving). Regulation and the negligence rule are most often concerned with precautions taken but not with the level of activity: a factory may be required by regulation to install smoke scrubbers but not to reduce its output. Thus injurers may not have incentives to moderate their level of activity although that would be desirable (their activity may result in harm despite the exercise of optimal precautions — even with smoke scrubbers, some pollution will result).
Weitzman’s (1974) conclusion that regulation could be superior to taxation rests on his assumption that the state must, in advance, set a corrective tax rate that is independent of the quantity of pollution. Yet, when the marginal harm depends on the quantity of pollution, the optimal tax rate depends on the quantity of pollution. See Roberts and Spence (1976). Kaplow and Shavell (1997) emphasize that taxes that depend on quantity are usually feasible to implement and are superior to quantity regulation. 56To be sure, tradeable permit regimes are themselves superior to quantity constraints imposed at the level of individual firms because trading allows a given total pollution target to be reached at minimum cost.
By contrast, under the corrective tax and strict liability, injurers pay for harm done, so that they will optimally moderate their level of activity (as well as efficiently choosing their level of precautions).
A fourth pertinent factor, noted above, is the ameliorative behavior of victims. Under regulation, corrective taxation, and other approaches that do not compensate victims for their harm, victims have a natural incentive to take optimal precautions (or to relocate) because they bear their residual losses; they will want to take any precaution (install air filters to reduce pollution) whose cost is less than the reduction in harm it accomplishes. Under a strict liability rule, however, a victim might not have such an incentive because he would be compensated for his losses. But under a negligence rule, victims are not compensated if injurers have behaved properly, and, under strict liability, compensation might be given only to victims who took optimal precautions (if this can be determined).57
Still another factor is administrative costs, the costs borne by the state in applying a legal rule and the legal and related costs borne by the affected parties (aside from direct costs, such as the costs of precautions). Liability rules possess a general administrative cost advantage over regulation in that under liability rules, administrative costs are incurred only if harm is done. This advantage may be significant when the likelihood of harm is small. Nevertheless, administrative costs will sometimes be lower under other approaches. For example, compliance with a regulation may readily be detected in some circumstances (determining whether factory smokestacks are sufficiently high would be easy) and also may be accomplished through random monitoring, saving enforcement resources. Also, imposing corrective taxes might be inexpensive. Notably, suppose that they are levied at the time of the purchase of a product. Last, the ability of injurers to pay for harm is of relevance. For liability rules to induce potential injurers to behave appropriately, injurers must have assets sufficient to make the required payments; otherwise they will have inadequate incentives to reduce harm, as discussed in section 2.6. Where the inability to pay is a problem, bonding requirements may be helpful, and regulation may become more appealing (although it may need to be enforced through the threat of nonmonetary, criminal sanctions). In addition, corrective taxes have an advantage over liability rules when harm is probabilistic because, under the corrective tax, an injurer would pay only the expected harm (with certainty) rather than the actual harm (if there is a 1% chance of causing$1,000,000 of harm, the payment would be only $10,000). Many firms that would be able to pay the tax and thus have correct incentives would not be adequately deterred under a liability rule, on account of their inability to pay for harm when it actually occurs.
For further discussion of this aspect of liability rules, see section 2.1.
3.6.3. Resolution of externalities through bargaining by affected parties. Parties affected by unregulated externalities will sometimes have the opportunity to make mutually beneficial agreements with those who generate the externalities. In the classic example, if a factory’s pollution causes harm of $1,000 that can be prevented by installing a smoke scrubber that costs $100, then, in the absence of any legal obligation on the factory, one would expect a
potential victim of pollution to pay the factory to install the scrubber. An agreement for any amount between $100 and $1,000 would be mutually beneficial. Let us first consider this possibility and then evaluate its significance.
If it is posited that there are no obstacles to reaching a mutually beneficial agreement concerning externalities, then that will occur. This tautology is one version of the Coase Theorem; Coase (1960) stressed the point that externality problems could be remedied through private bargains. A closely related version of the Coase Theorem asserts that the outcome as to the externality — whether a smoke scrubber is installed or pollution is generated — does not depend on the legal rule that applies. For example, if the scrubber costs $100 and there is no law
that controls pollution, a bargain as we have described it will come about and the scrubber will be installed; and likewise if there is a law that leads to installation of the scrubber, the same will happen.58 The outcome, however, might be affected by the legal rule because of the level of
wealth of parties. Most obviously, the potential victims might not have assets sufficient to pay for the scrubber, in which case the scrubber would not be installed unless a legal rule leads to this; moreover, legal rules may affect the distribution of wealth and thus the demand for goods, including that of being free from pollution.59 There are, however, many obstacles to bargaining. Bargaining may fail to occur when victims are numerous and face collective action problems in coming together. This is often the situation with respect to victims of industrial pollution. Similarly, in important contexts, bargaining will be impractical because victims will not know in advance who will injure them; this is the case for automobile accidents and most other accidents between strangers.
58Similarly, if there is a law permitting victims to enjoin factories from polluting but pollution does less harm than it costs to prevent, the factory would pay the victim to forgo the injunction, resulting in the same outcome — pollution — as would occur with no regulation of pollution.
59The outcome following from a legal rule might also be affected by an “endowment effect,” wherein individuals’ valuations depend on whether or not they originally enjoy legal protection. See Kahneman, Knetsch, and Thaler (1990).
3.7. Property Rights in Information
Legal systems accord property rights in information, including inventions, books, movies, television programs, musical compositions, computer software, chip design, created organisms, and trademarks. The generation and use of such information, and therefore the law governing it, is growing increasingly important in modern economies. We divide our review of this subject into three parts: First, we discuss certain information like an invention that can be used repeatedly to produce something; here we discuss patent, copyright, and trade secret law. Second, we examine diverse other types of information, such as where oil is likely to be located, and its legal protection. Third, we consider labels of various types and their protection under trademark law.
3.7.1. Inventions, compositions, and other intellectual works of repeat value. The classic forms of intellectual works that receive legal property rights protection are inventions and literary, musical, or other artistic compositions. The well-known description of socially optimal creation and use of such intellectual works is as follows. First, it is socially optimal for an intellectual work, if created, to be used by all who place a value on it exceeding the marginal cost of producing or disseminating the good (or service) embodying it; thus a new mechanical device should be used by all who place a value on it exceeding the cost of its manufacture, and a book by all who value it more highly than its printing cost.
Second, an intellectual work should be created if the cost of doing so is less than its total value to the public, net of production cost. Given this description of social optimality, the advantages and disadvantages of property rights in intellectual works are apparent. In the absence of property rights, a creator of an intellectual work will obtain profits from it only for a limited period — until competitors are able to copy the creator’s work. Thus, the generation of intellectual works is likely to be suboptimal.
But if there exist property rights, whereby a creator of an intellectual work obtains a monopoly in goods embodying the work, incentives to produce the works will be enhanced (although they will still be less than ideal because innovators do not capture all of the surplus that their works create).60 The major drawback to intellectual property rights, however, is that monopoly pricing leads to socially inadequate production and dissemination of intellectual works.61 This problem can be severe where the monopoly price is much higher than the cost of production.
60Kitch (1977) emphasizes a somewhat different view, under which patent rights are often granted at an early stage of invention, and the rights allow their holders to develop the inventions into commercially viable products.
61Relatedly, subsequent innovators whose inventions depend on prior patented works will need to obtain licenses from existing patent-holders, and hold-up problems may arise. See Chang (1995), Green and Scotchmer (1995), and Heller and Eisenberg (1998).
A good example is computer software, which may be sold for hundreds of dollars a copy even though its cost of dissemination is essentially zero. Another problem (with patent rights in particular) is the race to be the first to develop intellectual works. Given that the rights are awarded to whoever is first, a socially wasteful degree of effort may be devoted to winning the race, for the private award of the entire monopoly profits may easily outweigh the social value of creating a work before a competitor does.62
Patent law and copyright law are the most familiar forms of legal intellectual property right protection.63 The extent of protection afforded by each body of law is partial in various dimensions, however, so that they might be considered to represent a compromise between providing incentives to generate intellectual works and mitigating the monopoly problem. Patents and copyrights are limited in time (usually 20 years for patents, and the author’s lifetime plus 50 years for copyrights) and also in scope.64 As an example of the latter, the copyright doctrine of fair use often allows a person to copy short portions of a copyrighted work. This probably does not deny the copyright holder significant revenues (a person would be unlikely to purchase a book just to read a few pages), and the transaction costs of the copier having to secure permission would be a waste and might discourage his use.
A distinct form of legal protection is trade secret law, comprising various doctrines of contract and tort law that serve to protect not only processes, formulas, and the like that might be protected by patent or copyright law, but also other commercially valuable information such as customer lists. An example of trade secret law is the enforcement of employment contracts stipulating that employees not use employer trade secrets for their own purposes.
A party can obtain trade secret protection without having to incur the expenses and satisfy the legal tests necessary for patent or copyright protection. Also, trade secret protection is not limited in duration (Coca-Cola’s formula has been protected for over a century). However, trade secret protection is in some respects weaker than patent protection; notably, it does not protect against reverse engineering or independent discovery. On the economics of trade secret law, see Friedman, Landes, and Posner (1991).
The economic literature on intellectual property, focusing on patents, is discussed in Scherer and Ross (1990) and Tirole (1988); see also the historical review in Machlup (1958) and Reinganum’s (1989) survey on the timing of innovation.
An interesting and basic alternative to property rights in information is for the state to offer rewards to creators of information and for information that is developed to be made available to all who want it.65 Thus, under the reward system, an author of a book would receive a reward from the state for the writing of the book — possibly based on sales of the book — but anyone who wanted to print it and sell it could do so. Like the property rights system, the reward system encourages creation of information because the creator gains from producing intellectual works.
But unlike the property rights system, the reward system results in the optimal dissemination of information because the intellectual works are placed in the public domain; anyone may use them for free. Hence, the reward system may seem to be superior to the property rights system. A major problem with the reward system, however, is that the state needs information about the value of innovations to determine rewards. We note that, to some degree, society does use a system akin to the reward system in that it gives grants and subsidies for basic research and for other intellectual works. But society does this largely when these intellectual works do not have direct commercial value.
See Besen and Raskind (1991) and Landes and Posner (1989).
64See Gilbert and Shapiro (1990), Kaplow (1984), Klemperer (1990), and Scotchmer (1996, 1998).
65See Kremer (1998), Shavell and van Ypersele (1998), and Wright (1983).
3.7.2. Other types of information. There are many types of information different from what we have discussed above. One type of information is that which can be used only a single time, for example, where oil is located under a particular parcel of land. With regard to this type of information, there is sometimes no need for property rights protection. If the party who possesses the information can use it himself (to extract the oil), then once he does so, the issue of others learning it becomes moot — there will be no further value to the information. To the degree, though, that the party is unable to use the information directly (perhaps he cannot conveniently purchase drilling rights), his having property rights in the information might be valuable and beneficially induce the acquisition of information.66 Moreover, we observe that giving property rights in the information will not undesirably reduce the use of information when the optimal use of it is only once. In fact, the legal system usually does furnish property rights protection in such information as where oil is located through trade secret law and allied doctrines of tort and contract law.67
Another type of information is that relevant to future market prices. Here, the private and the social value of gaining such information can diverge, as emphasized by Hirshleifer (1971). For example, a person who first learns that a pest has destroyed much of the cocoa crop and that cocoa prices are therefore going to rise can profit by buying cocoa futures. The social value of his information inheres principally in any beneficial changes in non-financial behavior that it brings about. For example, an increase in cocoa futures prices might lead candy producers to reduce wastage of cocoa or to switch from chocolate production to production of another kind of candy. But the profit that a person with advance information about future cocoa prices makes can easily
exceed its social value (suppose he obtains his information only an hour before it would otherwise become available, so that it has no social value) or fall short of its social value (suppose that he obtains information early on, but that his profits are low because he has limited funds to invest in futures).
Hence, it is not evident whether it is socially desirable to encourage acquisition of such information about price movements by giving individuals property rights in the information. The law does not generally discourage such information acquisition (but an exception is regulation of trading based on insider information), and the law often encourages acquisition through trade secret protection.
In addition, firms may need to be able to prevent employees from diverting a firm’s benefit to themselves.
67See also our discussion of disclosure in section 4.1.2 on contract law.
68On insider trading, see Leland (1992) and Scott (1998).
Last, consider information of a personal nature about individuals. The cost of acquiring this information is the effort to snoop, although the information is sometimes adventitiously acquired, so costless. The social value of the information involves various complexities. The release of information of a personal nature to the outside world generally causes disutility to those persons exposed and utility for others, the net effect of which is ambiguous. Further, a person’s behavior may be affected by the prospect of someone else obtaining information about him: he may be deterred from socially undesirable behavior (such as commission of crimes) or from desirable but embarrassing-if-publicly-revealed behavior, and he may make costly efforts to conceal his behavior. Thus, there are reasons why the acquisition and revelation of personal information are socially undesirable, and reasons as well why they might be socially beneficial. The law penalizes blackmail and in this way attempts to discourage profit from acquisition of personal information. But otherwise the law does not generally retard the acquisition of personal information, and it also extends limited property rights in such information; notably, an individual who wants to sell to a publisher personal information he has obtained usually can do so.69.As this brief discussion has illustrated, the factors bearing on the desirability of protecting property rights in information vary significantly according to the type of information and call for analysis quite different from that concerning information of repeat value that we considered above.
3.7.3. Information valuable as labels. Many goods and services are identified by labels. The use of labels has substantial social value because the quality of goods and services may be hard for consumers to determine directly. Labels enable consumers to make purchase decisions on the basis of product quality without going to the expense of independently determining their
quality (if this is even possible). A person who wants to stay at a high quality hotel in another city can choose such a hotel merely by its label, such as “Ritz Hotel”; the consumer need not directly investigate the hotel. In addition, sellers will have an incentive to produce goods and services of quality because consumers will recognize quality through sellers’ labels. The existence of property rights in labels — that is, the power of holders of the rights to prevent other sellers from using holders’ labels — is necessary for the benefits of labels to be enjoyed.
In view of the social value of property rights in labels, it is not surprising that the legal system allows such rights, according to trademark law. Also, trademarks are of potentially unlimited duration (unlike patents or copyrights), which makes sense because the rationale for their use does not wane over time.