1. Illustrate with a real life example how well-defined, exchangeable property r
ID: 1188616 • Letter: 1
Question
1. Illustrate with a real life example how well-defined, exchangeable property rights(exclusive, transferable, and enforceable) will lead to economic efficiency.
2.) Using a two-period model, illustrate the maximization of net benefits over time. Assume the demand curve be P=10-0.4Q, marginal extraction costs are constant at $2/unit, and a resource constraint of 30 units, use 10% discount rate.
a. How much resources are allocated in periods 1 & 2?
b. What are the net benefits in periods 1 & 2? What is the total net benefit?
Explanation / Answer
ANSWER
As a final advantage of management of resources through private property rights, there is a measure of equity in having those people who use a resource (or wish to reserve it for use) pay for it by sacrificing some of their wealth. The proceeds from the sale of public assets could be distributed, or invested and perpetually distributed to the poor or others. For example, those using the forests would be required to pay a fee, whether it be for recreation, timber harvest, or even research in a unique area.
The market, as we describe it here, is a marvelous mechanism. Its workings, however, crucially require that property rights to each resource (especially the right to exclude) be privately held and easily transferable. Only if these conditions are met can we be assured that a decision maker (the owner) with an appropriate stake in the resulting decisions (his estimate of what the resource is worth in his use or on the market) will have reason to devote the appropriate amount of attention (but not too much) to how the resource can be used in its highest value (including the potential value to others in their use).
If property rights to the resource are not fully defined and enforceable, those who put a relatively low value on its use may nevertheless use the resource without the need to compensate (or outbid) anyone else. Or, should rights be controlled by a public (or a nonprofit) decision maker who cannot personally gain from more efficient utilization of the resource, waste could occur. The decision maker maximizes his advantage from limited property rights by minimizing his hassles (which he would face from hard decisions in reallocation) or by insuring his future job promotion (by giving in to the desires of politically powerful groups).
If rights are privately owned but not easily transferable (as in the case of agricultural water rights desired for industrial use nearby) another problem emerges. In this case, the farmer is forbidden by law to sell water to the industrial user (because unmeasured return flows might decline, injuring downstream holders of water rights). This prohibition may lead the farmer to irrigate wastefully and thus lose much water to evaporation, even though he would be quite willing to sell the water he consumes to the industrialists at a price both would find compatible.
In brief, when private rights are securely held by private individuals, but easily transferable, the resulting pattern of resource utilization would be difficult to improve upon. This follows directly from the fact that resources are easily mobile, markets provide clear and condensed information on relative values, and each person has the incentive to seek out and fill (and profit from) better uses for each resource.4 The next two sections will point out in some detail the problems which result in both the market and nonmarket sectors when property rights are undefined, unenforced, not owned by private parties, or when transfer is impeded.
As we mentioned above, market failure occurs when property rights are not properly specified, or are not held by those who can benefit personally by putting the resources to the use most highly valued by participants in the market. These market failures have long been recognized, but are frequently not traced to their origins in imperfect property rights.5In this section we discuss the consequences of not specifying clear property rights.
A common reason to distrust market outcomes is the possibility of monopoly. If one individual or firm controls the entire supply of a resource (natural diamonds, for example), that individual has an incentive to limit output not only to reduce production costs, but also to increase price. If there are no good substitutes available to users of the resource, a price well above the cost of added production may benefit the resource owner most. This would be inefficient, in the sense that some units remain unproduced even though they would be valued by users more than others value the inputs required for their production. In this situation the owner of resource rights is presumed to be unable to sell to individuals at any lower price without simultaneously lowering his price on all units.6
Another frequently cited cause of market failure is the existence of externality. An externality exists when some results (positive or negative) of a decision are not visited upon the decision maker. The classic case of negative externality is air pollution. Since John Evelyn wrote "Fumifugium" about the foul air of London in 1661, there has been public concern about the harm caused some people by smoke produced by others. When the copper producer chooses to send sulfur dioxide into the air, instead of bearing the costs of filtration, he saves money and thus benefits; yet the farmer downwind, whose alfalfa turns brown, pays the penalty and bears the cost. The results of such negative externalities are usually perceived to be inequitable. If the cost of reducing the pollution is less than the damage a reduction would avoid, the pollution also is inefficient. In general, negative externalities are overproduced. The standard economic approach to pollution, and to potential solutions, is set out skillfully, in a nontechnical fashion by Larry Ruff in "The Economic Common Sense of Pollution," The Public Interest (1970). An early property rights approach is in J. H. Dales, Prices, Property Rights, and Pollution (1968).
A related problem sometimes exists. Positive externalities exist if a decision maker's actions yield benefits to others, without compensation. If my neighbor continues to grow wheat on his land, rather than stripmine the coal below, I enjoy the view without having to pay him. He therefore does not consider my values when negotiating with coal buyers and deciding how to use his land. In general, external benefits are underproduced.
We can fruitfully consider both negative and positive externalities as property rights problems. In the example above, both the copper producer and the farmer use the air resource. The copper smelter uses the air as a garbage removal service, to carry away its waste, while the farmer's alfalfa plants "breathe" it. Farmers actually own the air in the sense that, if they are damaged by pollution, they can sue to recover damages.7 This right to clear (non-damaging) air is imperfect, however, since the farmer here would have to prove in court: (a) the total value of damages, (b) the fact that pollution caused the damages, and (c) that the smelter was indeed responsible for the foul air when damages occurred. This burden of proof is difficult (expensive), and so the property right seldom forces the air user to compensate the owner. Air pollution is similar to a hypothetical case where a copper producer could take labor or capital or copper ore for its own use without paying for it. Any such free resource is likely to be overused:8
We can approach the problem of negative externality in a slightly different manner by considering it a failure of law regarding liability. For example, the owner of an automobile does not have the right to use it to injure others (or their property), and is held liable for damages arising from the use of his auto. Similarly, we might also hold the owner of a copper smelter responsible (liable) for damages from the operation of his smelter. In a different setting, the implications of alternative liability laws are examined by Roland McKean, in "Products Liability: Implications of Some Changing Property Rights," Quarterly Journal of Economics (1970).
The second case given above of the "free" view enjoyed without compensation again reflects a failure of the rights to control (and to exclude others from the enjoyment of) all output from the land resource. The scenic view is a byproduct for which no credit is received%u2014or foregone when production stops. A classic article showing the property rights aspects of action where a decision maker does not pay the costs or gain the benefits from those actions is Ronald Coase, "The Problem of Social Cost," The Journal of Law and Economics(1960). Coase shows that in the absence of transactions costs (the costs of reaching a final bargain among parties) it does not matter who owns a given resource, except that wealth will change. That is, resource allocation is unchanged to the extent that individual preferences are invariant to the change in wealth caused by different assignments of property rights.
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