Introduction of property rights: definition and types

1. INTRODUCTION

In earlier chapters we have discussed at length the phenomenon of ‘exchange’, but until now it has simply been assumed that exchange takes place in goods or services (or in the x and y of our arithmetical example) and that these goods and services are valued because of some physical or technical characteristics. Further progress in piecing together a coherent picture of the firm requires that we refine our concept of what it is that people trade with one another. Occasionally in microeconomics textbooks, the idea is encountered that utility or satisfaction derives not from ‘goods’ in themselves but from their ‘characteristics’. Thus, in Lancaster’s (1966) framework we gain satisfaction not from toothpaste as such but from ‘decay prevention’ and ‘mouth freshening’ qualities which the toothpaste provides. Similarly, in Becker’s (1965) approach, households are ultimately concerned with ‘commodities’ which may be produced by using inputs of various market goods. Thus, a visit to friends may be the desired end (the ‘commodity’) which requires us to use the ‘goods’ car service, petrol, shoe leather and so forth, along with a certain amount of time, if we are to achieve it.

These ideas suggest an even more general proposition. It is not goods in themselves which give satisfaction. It is what people are entitled to do with these goods which really counts. Of course, in the simple case involving an exchange of apples and nuts, so often explored in the economics textbook, the question of the ways in which we could use these physical entities to yield utility barely arises. Even here, however, we might observe that whereas the purchase of an apple entitles us to eat it, or cook it, we are not (say) entitled to propel it through our neighbour’s window, or to drop the core carelessly on the public highway, or to ferment more than certain limited amounts of cider, and so forth. Thus, when people exchange apples and nuts, the physical goods change hands, but that physical transaction is the visible manifestation of something more fundamental. The trade is more correctly seen as an exchange of property rights in the apples and the nuts.

In the case of more complex commodities, the idea is more obvious. The market in the stock of housing, for example, involves the exchange of rights in the stock, and these property rights can be subdivided in such a way that several different people may have different rights in the same physical asset. Consider the legal ‘owner’ of a house. Such a person has the right to occupy the premises (‘usus’); may alternatively let the house to someone else and charge that person (the tenant) a rent (‘usus fructus’); may, within limits, allow the house to deteriorate; or may improve it and change it in a beneficial way (‘abusus’). In all these things, the owner is not entirely uncon­strained. Ownership does not imply being able to do anything we like.

1. If the owner occupies the premises, there may be limitations on its use. He or she may be forbidden from keeping a caravan in the front garden or chickens in the back, or from painting the windows red. These activ­ities may be forbidden because the original builder or developer of the house, wishing to create a favourable environment and thus to sell the houses for the highest possible price, judged that people will be pre­pared to pay more for houses free from the possible disamenities of neighbouring painters in tasteless red or lovers of noisy animals. By maintaining a right to prevent such activities, the developer is effectively instituting private ‘zoning’ arrangements which may be a less costly solution to these environmental problems than relying on negotiations between the occupants of neighbouring houses after they have all moved in. Whatever may be the economic rationale of the pri­vately established ‘chicken-free zone’, for the moment the important point is that the bundle of rights purchased by the ‘buyer’ of a house is not all encompassing.
2. If the owner lets the property, he or she thereby transfers the rights of use to the tenant. The tenant now has a bundle of rights in the use of the house. The landlord can no longer enter the house when he or she likes, may possibly be forbidden from charging more than a specified rent (if there is rent control), and may have to give a certain length of notice to the tenant. The tenant on the other hand has the right to live in the house and use the assets for a specified period of time. Under rent control the tenant may have ‘security of tenure’ so that he or she has the right to use the stock for as long as desired providing he or she pays the rent. This right of use might even be inherited by descendants of the tenant.
3. The right of an owner (or a tenant) to change the asset may be severely limited. As was mentioned in Chapter 2, building an extension to a house will normally require gaining the consent of the local authority planning department who thereby have considerable influence on the amount and type of development.

All these factors influence what a person can do with housing resources and hence the benefit that is derivable from them. The value to an individual of any resource thus depends on the property rights associated with it. As Demsetz (1967) puts it: ‘Property rights are an instrument of society and derive their significance from the fact that they help a man form those expectations which he can reasonably hold in his dealings with others . . . An owner of property rights possesses the consent of fellow men to allow him to act in particular ways’ (p. 31).

2. TYPES OF PROPERTY RIGHTS

2.1. Private Rights

When it is said that a person has private rights in any resource, it means that the particular person concerned and no one else has the authority to decide how the resource should be used. As we have seen, this does not imply that the person is unconstrained in his or her choice. The choice must be from a ‘non-prohibited class of uses’ (Alchian, 1977b, p. 130), but the individual person with private property rights can prevent other people from using the resource in ways of which he or she does not approve. It is important to understand that this definition does not imply that all the property rights associated with a given resource are in the hands of a single person. Rights to use a resource may be partitioned between two or more individuals, as in the case of landlord and tenant, but the rights held by the landlord and the rights held by the tenant in the housing stock are private rights. The landlord can prevent the tenant, or anyone else, physically changing the housing stock or subletting it to another person (unless, of course, the tenant has purchased the latter right from the landlord). The tenant can prevent the landlord from using the stock for his or her own private pur­poses. Thus, the fact that different people have rights in the same physical asset does not necessarily imply that these rights are not private. So long as each person holds different rights, and the exercise of one person’s rights in no way impinges upon the exercise of the other person’s rights, both people have private rights in the resource.

2.2. Communal Rights

There are instances in which a person’s right to use a resource in a certain way is held in common with another person or group of people. My right to walk across common land is the same right as that held by everyone else with access to that land. I may use the resource for the purposes of walking, or gathering firewood, or grazing animals, or whatever, but so also can other people. Other important examples of communal rights might include the right to use a watercourse for the disposal of waste products, or the right to fish on a particular stretch of water or at sea, or the right to allow smoke or other waste gases to escape into the air. In each case, a resource (a river, a lake, the sea or the air) may be used for the same purpose by many individuals. The analytical consequences of communal property will be dis­cussed in a later section, but it will be obvious enough that the problems of ‘congestion’, ‘over-fishing’, and water and air ‘pollution’ are bound up with this question of property rights. Communal property rights, however, do not necessarily imply ‘overuse’ of resources if the group of people who hold these rights in common is restricted to an ‘appropriate’ size.² Thus, a landowner with private rights to the fishing on a particular stretch of river may decide to restrict the use of the river to a selected group of other people. These people can buy a communal right to fish from the landlord, and any landlord wishing to maximise his or her income from selling these communal rights (licences) will wish to restrict their number.

2.3. Collective Rights

With communal rights, each individual makes his or her decision as to when or how to exercise it. If I am going fishing, I do not have to consult the other people who may also have this right. In the case of a collective right or shared right, the decision about the use of a resource is taken as a group. For example, a group of individuals may form a consortium which ‘owns’ a racehorse. This does not imply that individual members of the con­sortium can enter the horse in whatever race they please, or that they can decide independently on how the horse should be treated. Rather, it implies that some collective decision has to be taken about the training and sport­ing commitments of the horse. This will usually (though not necessarily) imply using some voting process to choose a particular person who will make the detailed decisions which most of the members of the consortium may be ill equipped to make. Once a person has been appointed to this posi­tion, the necessary private property rights which will enable him or her to execute decisions and prevent other non-qualified people from making decisions will inhere in that person. A collective right to determine the use of a resource and to share in the results is quite different therefore from a private or indeed communal right. The manager of the resource will exer­cise the private rights which go with executive decision-making.³ These rights will remain for so long as the consortium believes they are being exer­cised sufficiently effectively on their behalf and it is therefore not worth the time and trouble involved in changing the manager.

2.4. Exchangeable Rights

All trade concerns the exchange of property rights, but not all property rights are tradable. Consider, for example, the tenant in a rent-controlled apartment. Such a tenant has the rights of use which we discussed earlier. These rights have no market value, however. The tenant cannot sell the rights to live in a particular house at a controlled rent to anyone else. This lack of tradability can have important consequences, as the eclipse of the private rented sector in the UK helps to testify. Suppose, for example, the value of a house available for owner-occupation on the market was £50,000. Now imagine that the same house has a tenant paying a below-market rent set by a controlling agency. Clearly, the value of the house with a sitting tenant will be less than £50,000 (perhaps £30,000) depending upon the level of the controlled rent, expectations concerning the future of rent control, or the likelihood that the tenant will move. The result is that the market value of the tenant’s rights (zero) plus those of the landlord (£30,000) falls short of the value of the property unencumbered by the tenant (£50,000). It follows that both landlord and tenant will have a mutual interest in changing the allocation of property rights in the house. By creating a free­hold, there is a potential £20,000 of capital gain to be shared between them. Thus the tenant might offer the landlord (say) £40,000 for his or her rights in the house. This is £10,000 more than their value on the market, but by combining the landlord’s and tenant’s rights in this way, the tenant creates the freehold which, as we saw, was worth £50,000. Both landlord and tenant thus each make a gain of £10,000.

This example is an illustration of an important principle which will be encountered again in differing disguises. The nature of property rights in resources is expected to change when someone perceives that existing rights holders could all be better off by agreeing to such a change. Sometimes this will involve combining hitherto separately held rights in a single holder (as in the landlord-tenant example under rent control). Sometimes, though, it might involve disentangling different rights, at present held by a single person, and then allocating them to different people. Financial markets provide examples of this process. A government bond which promises to pay £5 per year until repayment of the principal in the year 2010 can be held by a single person, but the right to £5 per year until 2010, and the right to the prin­cipal (say £100) in 2010, are quite distinct and could be sold separately on the market. If the market values of the two separate rights sum to more than the market value of the combined rights (the bond) it will pay some financial intermediary to buy bonds and split them down into their component parts.⁴

Just as private rights may be exchangeable or non-exchangeable, the same applies to collective and communal rights. Consider first the case of communal rights. The purchase of a licence to fish in a particular area results, as we saw, in a communal right (unless of course there is only a single licence). This right may or may not be tradable. If I break my arm after buying the licence, I may be able to sell it to someone else, in which case possession of some document is presumably sufficient to procure admission. If, on the other hand, the licence applies to a single named indi­vidual, it is worthless to anyone else, and will have no exchangeable value. Membership of a club which allows people access to some communal prop­erty constitutes another example. Usually such communal rights are not marketable for the simple reason that when communal access to some resource is involved, the other members of the club will want a say in decid­ing the eligibility of new members.⁵ Willingness to pay the highest entry fee may not be the deciding criterion. Assessment of character and the proba­bility that the new member will take due care of the communal property may be equally important. On the other hand, the incentive to take care of communal property would appear to be stronger when rights of access are exchangeable than when they are not, since failure to do so will be reflected in a falling market value of club membership as facilities deteriorate.

Company shares represent the classic case of exchangeable collective rights. Members of the consortium that owned the racehorse in our earlier example would normally be able to sell their ‘share’ in the racehorse to another person. We will be investigating the property rights structure of different types of company in more detail shortly. Collective rights in assets taken into ‘public ownership’, such as nationalised undertakings and departments of state, are clearly not exchangeable. This lack of transfer­ability is the crucial distinction between collective rights in the assets of the state and collective rights in the private sector. As Alchian (1965) expresses it: ‘The differences between public and private ownership arise from the inability of a public owner to sell his share of public ownership’ (p. 138).

The right of exchange may be exercised privately or collectively. In the case of the shares of a joint-stock company, the shareholder can trade his or her holdings without gaining the approval of other people. An individ­ual decision to buy and sell shares can be made at any time. It is for this reason that shares in a joint-stock company are usually regarded as private assets. In fact they are privately exchangeable titles to collective rights. The share is a bundle of rights, one of which (the right to exchange) is a private right. It is slightly paradoxical to note that in ‘private’ companies the right to exchange shares is more circumscribed and cannot be exercised purely privately. In the case of public ownership mentioned by Alchian, we might insist that a public owner can sell his or her share of ownership but only through the exercise of a collective right of exchange. Presumably this is what happened in the privatisation programmes pursued in many countries during the 1980s. Taxpayers collectively ‘decided’ through their representa­tive institutions of government to sell their collective rights in the assets of the nationalised industries.

2.5. Alienable and Inalienable Rights

Rights which cannot be reassigned to someone else are sometimes called ‘inalienable rights’. Because they cannot be reassigned, the entrepreneurial function of intermediation which we discussed in Chapter 3 has no scope to operate in a world of inalienable rights. Some rights must be alienable if there is to be any coordination problem to solve. Exchangeable rights are clearly alienable, but the converse does not hold. A manager’s rights to make decisions about the allocation of shared resources are not exchange­able but they are certainly alienable. A collective decision by shareholders can dismiss the manager.

2.6. Exclusion

If rights are to be exchangeable on the market they must, of course, be denied to people who have not acquired them through gift or exchange. If people cannot effectively be excluded from fishing a stretch of river because the costs of policing the river bank are very high, the market price of a licence will be zero. No one will voluntarily pay for a right they can without penalty acquire for nothing.⁶ Thus the ability to exclude others from using a resource is a necessary condition of exchangeability and hence of markets in property rights. If exclusion cannot be effected, the resource is perforce ‘communal’; we all have a right to grab what we can get. The converse does not hold: communal property may or may not permit exclusion, as was seen in the section on communal rights.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.