INSTITUTIONAL ECONOMICS: PROPERTY RIGHTS – THE FOUNDATION OF CAPITALISM

Until quite recently property rights were ignored by neoclassical economics. We shall discuss the nature and the types of property rights. We will then examine the recent new institutional economic analysis of property rights, focusing on the ‘Property Rights School’ and Williamson’s conception of exchange. Both approaches contain problems. Instead, we argue for the non-contractual approach.

A key point is that an exchange is not simply a two-way transfer of goods, services or money between agents: it involves a transfer of rights. Usually, economists fail to identify this. We shall claim that commodity exchange requires a combination of both state and customary institutions.

Property rights were defined as the right to exclude others from the use of an asset and the right to use, hire out or sell the asset to others. Property rights are thus a ‘bundle of rights’: to possess an asset and hold it (passive use); to exchange it or to let others use certain aspects of it temporarily (active uses). Property rights may be attached not only to physical assets but also to intellectual property.

Excludability is the defining characteristic of property rights. It means not only that others can be excluded from the benefits of an asset, but also that the owners are exclusively responsible for the costs of asset use, as well as the costs of ensuring exclusion. This form of capitalism relies on internalising benefits and costs, and the incentive structure works through the profit-loss signal (i.e. the price mechanism).

In practice, excludability is often imperfect and externalities are widespread. For property rights to work, other mechanisms (the state) are required.

We can distinguish between different types of property rights depending on their excludability and the nature of the exclusion:

• Private goods: where the costs and benefits of property use impact directly and exclusively on the property owner. Externalities arise when costs and benefits do not impact the property owner. Externalities can reduce the value of the asset, if excludability is difficult to establish and enforce.
• Free goods: no one has claimed property rights because they are not scarce. There is no economic problem with free goods (clean air, water and so on).
• Pure public goods: goods and services (e.g. street lighting, radio) for which there is no competing demand once they are provided. However, such public goods have to be provided out of collective resources.
• Common or collective goods: where exclusion of others from benefits is impossible or unnecessary. Such a good (e.g. medicine, foreign language groups) may be shared in a small, voluntary groups – club goods – from which outsiders are excluded. Or common property (e.g. defence, police, hospital) may be shared in a large, inclusive group with compulsory membership (socialised property). Open access to the public-domain goods can be assured either through socialised production (where the state owns the means of production, such as postal services, prisons), or by private institutions (e.g. elderly care, higher education and parks) that guarantee certain access conditions to the public. This access to public-domain goods can be achieved by certain regulations, and/or guided by the price mechanism using specific vouchers and subsidies.

Property rights changes with time and technology. Different societies will shape the property rights and exclusion mechanisms in differing ways.

Exclusion costs are incurred when owners employ resources to exclude others from owning or using the property; e.g. fences, locks, security alarms, property-titles registries and information-protection systems in computers. High exclusion costs lower the value of property. To a considerable extent, they depend on institutional arrangements (ethics of the community, social conventions, collective action of the legislation, police and judiciary). Low exclusion costs promote active uses of the property. However, they are threatened by civil strife, anti-capitalist ideologies and envy and criminal gangs.

Two other aspects of property rights:

• divisibility: Mere ownership rights can be separated from rights over specific uses of an asset; e.g. the title to a land separated from the right to hunt, walk and camp.
• transferability: Rights should be disposable through trade, gift and inheritance. Where transfer is prohibited, the asset (e.g. child) has inalienable right, and protects the owner of the asset from sale or rental.

Economic liberties are safeguarded by private autonomy. This means that the rights to property owners are free form detailed private and public limitations on how property is to be used. Autonomy can be curtailed when other property owners with power interfere with someone’s property rights by arbitrary and discriminatory action (e.g. restrictive trading practices). Autonomy can also be curtailed by government actions (e.g. prescriptive directives to land use).

A contract is an agreement, a declaration of will to exchange property rights. One party may wish to offer outright property ownership (sale) or the right to possess and use property for a limited time (loan or hire out). Typically, the other party offers an amount of money for the property. Exchange can be simultaneous or non-simultaneous (delivery or payment postponed to a future date). Non-simultaneous exchange opens up the potential for uncertainty, misunderstandings, disagreements and opportunism. Consequently, internal sanctions are required:

• self-enforcing contracts provide credible commitments. Some devices are ‘tit-for-tat’, the creation of a reputation and the provision of a security (offering ‘hostages’), or reliance on a intermediary to make contractual commitments more credible. Also merchant virtues, such as honesty, punctuality, a high payment morale, reliability and flexibility in conflict – intangible (soft) capital asset of the community.
• intermediaries: persons or organisations (e.g. shared ethnicity and formal associations) that intermediate between the ultimate buyer and seller. They reduce information costs and enhance trust; e.g. such agents operate to facilitate trade in environments like undeveloped capitalist societies, where impersonal institutions are not sufficient.
• an adjudicator or mediator is an independent person or organisation (e.g. chamber of commerce) who passes judgement on contested aspects of contract execution

In addition, self-enforcement of contracts is supplemented by external institutions, legislation and government regulation that rely on public enforcement organisations (the judiciary, the police, inspectors and prisons). Credible external enforcement mechanisms frequently enhance the confidence of contract partners.

There are several positive consequences.

• Civilising process: respect for and protection of property rights is beneficial in that it channels entrepreneurship, human energy, creativity and rivalry into constructive and peaceful directions.
• Political and wider rights: Private property rights give material substance to individual, social and political freedom, as economic liberties require democratic and legal constraints on government powers.
• Efficiency: Owners are normally induced to economies on resources (e.g. water).

However, there are harmful consequences.

• Risks and responsibilities: individuals carry more of the burden of risk and have to deal with any market consequences. Markets operate beyond any individual’s control so that they unfairly reward and penalise economic agents (e.g. linguists and craft-makers).
• Exclusion and disadvantaged: many individuals are excluded fromor disadvantaged in participating in the labour market. For example, single parents and housewives are involved in the domestic sphere, they may be excluded from the labour market. Immigrants are disadvantaged for racial and linguistic reasons.
• Merits of socialised property: greater inclusion and commitment to useful goods and social relationships.
• Destructive competitive powers: Private property rights leads to destructive competitive behaviour and anarchic coordination so that the economy is constantly on the verge of a crisis.

The Property Rights School argues that externalities, such as pollution and traffic noise, are best dealt with through government intervention. Instead a solution is found by developing and enforcing a system of defined individual property rights. Those inconvenienced by pollution and other externalities, would sue those responsible for the inconvenience.

Crucially, the establishment of a system of individual benefits and disbenefits is required. This is essentially the application of the classical liberal dogma: individual is best judge of its own welfare to instances of externality. To the Property Rights School, the structure of property rights refers to primarily to a set of incentives and disincentives (benefits and costs).

However, the scope of the government intervention is not reduced, as the School imagines. By extending the domain of formal, private and individual property and ownership, the state remains involved through extension and enlargement of litigational activity. It is a popular myth that the extension of formal property rights and commodity exchange necessarily involves a withdrawal of the state from social life. Government agencies constantly have to control, regulate and intervene to ensure the free working of the system.

Williamson argues that there is a tendency towards ‘legal-centralism’, in which disputes are regarded as being normally resolved by reference to the legal apparatus of the state. His main alternative theoretical construction is the idea of ‘hostages’ to support exchange. A ‘hostage’ refers to a class of arrangements where both parties to an agreement are committed to specific and non-recoverable costs (loss of reputation, cost of machinery, plant, skills and land). The effect is to tighten the bond between the two parties and to minimise the chance of default before the contract is completed. In addition, other arrangements (such as self-enforcement mechanisms and agreed arbitration procedure) aid contracting without recourse to a formal legal apparatus. Thus, in Williamson’s view, a system of exchange and contract is possible and sustainable without the state.

However, while most contractual disputes are resolved without recourse to courts, this does not mean that the legal system and the state have no place in the everyday process of contract. The basis of everyday contract is necessarily a combination of both the laws that are passed by government (formal legislation and legitimation), and also centuries of accumulated custom and tradition (less formal).

There is a problem of incomplete knowledge that affects any contractual arrangement. There is an element of uncertainty in all contracts; they are subject to varied possibilities to which we can assign no calculable probability, and thus cannot be envisaged in detailed contractual terms at the outset. To cope with uncertainty, individuals proceed by trial and learning, relying in part on experience and habits. In an uncertain world, we are forced to rely on institutional rules and standard patterns of contracts, with the assumption that other parties will similarly accept the prevailing norms and conventions.

The formulation of a contract between two parties involves a reference to set of norms, conventions, customs and rules rather than a detailed negotiation of every clause and eventuality. These non-contractual features of exchange agreements are central and functional to any economic system. For instance, extensive, unwritten conventions and rules govern day-to-day practice of industrial relations – a combination of custom and open negotiation. In case of business people, trust and fellowship are essential to facilitating buying and selling. Word of mouth, reputation and established relationships embed formal contracts.

However, whilst there are always non-contractual elements within any contract, in a developed capitalist system these do not dominate transactions. In some sense, the rational calculation of gain and loss is indeed predominant in a modern market economy. It is argued that the analysis of exchange in modern society has to be an examination of both contractual and non-contractual feature of an exchange.