Microeconomics for MBAs 2

The Meaning and Importance of Property Rights Property rights pertain to the permissible use of resources, goods, and services; they define the limits of social behavior and, in that w

book, as well as in specific chapters on topics such as regulation and deregulation, and price controls and consumer protection, we will examine the practical applications of economic theory

However, we hasten to add that this book and course are devoted primarily to

“microeconomic” theory and applications We make microeconomics our focus because the issues at stake are more relevant to the interests of MBA students and because the microeconomic theory is generally viewed as being sounder than macroeconomic theory Besides, we are firmly convinced that an understanding of the “macroeconomy” is

necessarily dependent on an understanding of the “microeconomy.”

In microeconomics we start with the proposition that all actions are constrained

by the fact of scarcity That is to say, in some basic way, scarcity—and the economic question of how to deal with it—touches all of us in how we do business and conduct our lives We now turn to a study of property rights Private “property rights” are one of the institutional mechanisms people have devised to help alleviate the pressing constraints of scarcity, which is why we take them up at this early stage in the course

The Meaning and Importance of Property Rights

Property rights pertain to the permissible use of resources, goods, and services; they

define the limits of social behavior and, in that way, determine what can be done by individuals in society They also specify whether resources, goods, and services are to be used privately or collectively by the state or any smaller group

Property rights are a social phenomenon; they arise out of the necessity for

individuals to “get along” within a social space in which all wish to move and interact Where individuals are isolated from one another by natural barriers or are located where goods and resources are abundant, property rights have no meaning In the world of Robinson Crusoe, shipwrecked alone on an island, property rights were inconsequential His behavior was restricted by the resources found on the island, the tools he was able to take from the ship, and his own ingenuity He had a problem of efficiently allocating his time within these constraints—procuring food, building shelter, and plotting his escape; however, the notion of “property” did not restrict his behavior—it was not a barrier to what he could do He was able to take from the shipwreck, with immunity, stores that he thought would be most useful to his purposes.5

After the arrival of Friday, the native whom Robinson Crusoe saved from

cannibals, a problem of restricting and ordering interpersonal behavior immediately emerged The problem was particularly acute for Crusoe because Friday, prior to coming

to Tibago, was himself a cannibal (Each had to clearly establish property rights to his body.) The system that they worked out was a simple one, not markedly different from

5

The absence of human beings affected also his idea of what was useful Crusoe, in g oing through the ship, came across a coffer of gold and silver coins: “Thou art not worth to me, no, not taking off the

ground; one of these knives is worth all this heap [of gold].” At first, he evaluated the cost of taking the coins in terms of what he could take in their place and decided to leave them But on second thought, perhaps taking into consideration the probability of being rescued, he took the coins with him! See

Robinson Crusoe by Daniel Defoe

that between Crusoe and “Dog.” Crusoe essentially owned everything Their

relationship was that of master and servant, Crusoe dictating to Friday how the property was to be used

The notion of property rights is broadly conceived by economists Property rights are most often applied to discussions of real estate and personal property (bicycles,

clothes, etc.); they are also applicable to what people can do with their minds, their ability

to speak, how they wear their hair, and if and when they must wear their shoes

In common speech, we frequently speak of someone owning this land, that house,

or these bonds This conventional style undoubtedly is economical from the viewpoint of quick communications, but it masks the variety and complexity of the ownership

relationship What is owned are rights to use resources, including one’s body and mind,

and these rights are always circumscribed, often by prohibition of certain actions To

“own land” usually means to have the right to till (or not to till) the soil, to mine the soil,

to offer those rights for sale, etc., but not to have the right to throw soil at a passerby, to

use it to change the course of a stream, or to force someone to buy it What are owned are socially recognized rights of action.6

Property rights are not necessarily distributed equally, meaning that people do not always have the same rights to use the same resources Students may have the right to use their voices (i.e., a resource) to speak with friends in casual conversation in the

hallways of classroom buildings, but they do not, generally speaking, have the right to disrupt an English class with a harangue on their political views However, the English professor, although his behavior is circumscribed, has the right to “allow” his or her political views to filter into the English lectures And if the President of the United States

walked into the same English class and began speaking extemporaneously on his (or her)

political views, it is not likely that anyone would object A person has the right to go

without shoes on a beach, but one does not always have the right to enter a restaurant

without shoes On the other hand, the restaurant owner’s best friend may have that right

By the same token, although undergraduate students generally pay a fraction of their educational expenses at state universities, they have the right to university facilities such

as tennis courts and the university bookstore, but nonstudent taxpayers do not have the same rights to these facilities

In other words, property rights can be recast in terms of the behavioral rules,

which effectively limit and restrict our behavior Behavioral rules determine what rights

we have with regard to the use of resources, goods, and services The rights we have may

be the product of the legislative process and may be enforced by a third party: usually the third party is the government or, more properly, the agents of government In this case property rights emerge from laws

On the other hand, rules that establish rights may not have third-party

enforcement In this case they carry weight in the decisions of individuals simply

because individuals recognize and respect behavioral limits for themselves and others They may do this because of the value they attach to “living up” to their contractual agreements, which may be implied in their associations with others, and because their

6

Armen A Alchian and Harold Demsetz, “The P roperty Rights Paradigm,” Journal of Economic History,

vol 33, p 17, March 1973

own rights may be violated if they violate the rights of others Two neighbors may

implicitly agree to certain modes of behavior, such as not mowing their lawns on Sunday mornings or playing their stereo equipment late at night.7 Their behavior may be in recognition of what it means to be a “good neighbor” and of what life can be like if limits

to their behavior are not observed The neighbor who starts his mower early Sunday morning may hear music late at night or may find his rights invaded in other ways More will be said on this, but for now we mean only to point out that the behavior of each through “offensive and counteroffensive” maneuvers may deteriorate into a state in

which both parties are worse off than they would have been if restrictions on their own

behavior were commonly observed From this we see the bases for behavioral rules or, what amounts to the same thing, property rights

Property rights are important to any inquiry of social order because it is on the

basis of suc h rights that the terms individual and state are given social meaning, that

actions are delimited, and that a specific social order will emerge The existing property rights structure is predicated upon specific social and physical conditions Changes in those conditions can cause a readjustment in the nature of social order

Property Rights and the Market

In the private market economy people are permitted to initiate trades with one another Indeed, when people trade, they are actually trading “rights” to goods and services or to

do certain things For example, when a person buys a house in the market, he is actually buying the right to live in the house under certain conditions, for example, as long as he does not disturb others This market economy is predicated upon establishing patterns of

private property rights; those patterns have legitimacy because of enforcement by

government and, perhaps just as important, because of certain precepts regarding the limits of individual behavior that are commonly accepted and observed.8 Without

recognized property rights there would be nothing to trade—no market

How dependent are markets on government enforcement for the protection and legitimacy of private property rights? Our answer must of necessity be somewhat

speculative We know that markets existed in the “Old West” when formally instituted

governments were nonexistent Further, it is highly improbable that any government can

be so pervasive in the affairs of people that it can be the arbiter of all private rights Cases in which disputes over property rights within college dormitories are settled by student councils are relatively rare, and the disputes that end up in the dean’s office or at police headquarters are rarer still Most conflicts over property rights are resolved at a local level, between two people, and many potential disputes do not even arise because of generally accepted behavioral limits

Finally, the concept of property rights helps make clear the relationship between the public and private sectors of the economy—that is, between that section of the

7

This is an example used by James M Buchanan, The Limits of Liberty (Chicago: University of Chicago

Press, 1975), p 20

8

In addition, there is considerable private enforcement of property rights Almost all people take some

measures to secure their own property They put locks on their doors, leave lights on at night, and alert their neighbors to take their newspapers in when they are out of town

economy organized by collective action through government and that section which is organized through the actions of independent individuals When government regulates aspects of the market, it redefines behavioral limits (in the sense that people can no

longer do what they once could) and can be thought of as realigning the property rights between the private and public spheres When the government imposes price ceilings on goods and services, as it did during the summer of 1971, it is redefining the rights that sellers have with regard to the property they sell One of the purposes of economics is to analyze the effect that a realignment of property rights has on the efficiency of

production

Anarchy: A State of Disorder

Property rights are so much a part of our everyday experience that we are inclined to think of them as being “natural,” a part of our birthright The Declaration of

Independence speaks of “certain unalienable rights.” Indeed, it is hard to imagine a world in which people interact within a defined social space without the existence of property rights The purpose of this section is to envision such a state in order to gain some insight into the origins of property rights and, therefore, social order

Thomas Hobbes, a seventeenth-century political scientist philosopher, envisioned

a state in which there was a complete absence of property rights, either those rights that have legitimacy because of their social acceptability or those that exist because of legal enforcement He called this “the state of nature,” and his analysis was not very attractive Because Hobbes gave very little credence to social acceptance as a basis for property rights, his attention was on the role of the state He believed that “during the time men live without a common Power to keep them in awe,” every man will be pitted against another in continual struggle for dominance and protection Life will be “solitary, poore, nasty, brutish, and short.” Where there is no state, he argued, there will be no law and

therefore, “no Property no Mine and Thine distinct, but only that to be every man’s that

he can get, and for so long as he can keep it.”9

One of Hobbes’ purposes in writing Leviathan was to justify the sovereign state

as an absolutely necessary political entity He tried to convince his contemporaries of the potential for conflict among men without the state; that it is necessary to hand over

considerable political power to the state in order that internal conflicts may be minimized

He argued that it is in man’s self- interest to swear full allegiance to the state

In order to make his argument as convincing as possible, it was somewhat natural for Hobbes to describe “the state of nature” in the worst possible terms One can accept the criticism that Hobbes exaggerated the need for the state without ignoring a

cornerstone of his argument: Without legally defined property rights, there is

considerable potential for conflict among men The life of man in the state of nature may not invariably be “solitary, poore, nasty, brutish, and short,” but it may be markedly less comfortable without property rights than with them

9

Thomas Hobbes, Leviathan, ed By C.B Macpherson [Baltimore, Md.: Penguin Books, Inc., 1968 (first

published 1651], pp 185–88

In an idealized world in which people are fully considerate of each other’s

feelings and adjust and readjust their behavior to that of others without recourse to

anything resembling a dividing line between “mine” and “thine,” property rights are no more necessary than they were for Robinson Crusoe alone on Tibago But in the world

as it now exists, there is the potential for conflict Granted, the potential may not be present in all our interpersonal experiences People have interests that, for all practical purposes, are independent of one another, and many of our interests are perfectly

congruent with the interests of those around us However, people have spheres of

interests (described for two people by the circle in Figure 1.1) that extend outward from themselves and that intersect with the interests of others A basic axiom of behavior (one

to be developed in greater detail later) is that most people want more than they have, which means they have an interest in, or can benefit from, that which others have In other words, they have competing interests—or, in terms of Figure 1.1, areas where their spheres of interests intersect It is here that the potential for conflict arises, that a

dividing line between “mine” and “thine” must be drawn

Figure 1.1 Individuals have spheres of interest,

which are illustrated, by the two circles The

intersection of the two circles represents the arc of

potential conflict between two individuals; it is the

area within which property rights (or behavioral

limits) must be established

Children at play provide us with a reasonably clear illustration of the absence of and potential for conflict among people in the larger community Children can often play together for long periods of time without conflict They each have interests that do not invade the interests of others (whic h may be described by the clear portions of the circles

in Figure 1.1); for example, one may want to play with a truck, one with a bucket and shovel, and another with toy cowboys For periods, their behavior may approximate the idealized society mentioned above On the other hand, when two children want to play with the same toy or play the same role of mother or father in their game of “house,” or when one child wants to take over the entire sandbox, conflict is revealed, first with harsh words, possibly in fights, leading to a breakdown of their social interaction—play

Conflict or the potential for conflict can be alleviated by the development of property rights, held either communally, by the state, or by private individuals These rights can be established in ways that are similar but which can be conceptually

distinguished: (1) voluntary acceptance of behavioral norms with no third-party enforcer,

such as the police and courts, and (2) the specification of rights in a legally binding

“social contract,” meaning that a third-party enforcer is established Most of what we say for the remainder of this chapter applies to both modes of establishing rights However, for reasons developed later in the book, the establishment of rights through voluntary

acceptance of behavioral norms, although important in itself, has distinct limitations, especially in relation to size More specifically, many behavioral norms have a tendency

to break down in large-group settings Because most people hold to the behavioral norm that they should not pollute, and yet at least to some degree they pollute anyway, and because legal codes are filled with specifications of property rights, meaning something has failed, the limitations of behavioral norms may come as no surprise Be that as it is, holding the discussion of voluntary behavioral rules until later in the book will permit us

to narrow our attention and, perhaps, gain a deeper understanding of the basis of legal property rights For now, let’s step back and consider in more detail the social basis for property rights

The Emergence of Property Rights

To develop the analysis in the simplest terms possible, consider a model of two people, Fred and Harry, who live alone on an island They have, at the start, no behavioral rules

or anything else that “naturally” divides their spheres of interest That is, they have nothing that resembles property rights Further, being rational, they are assumed to want more than they can produce by themselves Their social order is essentially anarchic Each has two fundamental options for increasing his welfare: He can use his labor and other resources to produce goods and services or he can steal from his fellow man With

no social or ethical barriers restricting their behavior, they should be expected to allocate their resources between these options in the most productive way This may mean that each should steal from the other as long as more is gained that way than through the production of goods and services

If Fred and Harry find stealing a reasonable course to take, each will have to

divert resources into protecting that which he has produced (or stolen) Presumably, their

attacks and counterattacks will lead them toward a social equilibrium in which each is applying resources to predation and defense and neither finds any further movement of resources into those lines of activity profitable.10 This is not equilibrium in the sense that the state of affairs is a desirable one; in fact, it may be characterized as a “Hobbesean jungle” in which “every man is Enemy to every man.”

In an economic sense, the resources diverted into predatory and defensive

behavior are wasted; they are taken away from productive processes If these resources are applied to production, total productio n can rise, and both Fred and Harry can be better off—both can have more than if they try to steal from each other It is only through winding up in a state of anarchy or seeing the potential for ending up there that they must question the rationality of continued plundering and unrestricted behavior; and it is

because of the prospects of individual improvement that there exists a potential for a

“social contract” that spells out legally defined property rights Through a social contract they may agree to place restrictions on their own behavior, but they will do away with the restraints that, through predation and required defense, each imposes on the other The fear of being attacked on the streets at night can be far more confining than laws that

10

For a rather difficult discussion of “equilibrium” under anarchy, see Winston C Bush, “Individual

Welfare in Anarchy,” in Gordon Tullock (ed.), Explorations in the Theory of Anarchy (Blacksburg, Va.:

University Publications, Inc., 1972), pp 5–8

restrict people from attacking one another This is what John Locke meant when he

wrote, “The end of law is not to abolish or restrain but to preserve and enlarge

freedom.”11

Once the benefits from the social contract are recognized, there may still be, as in

the case of voluntary behavioral norms, an incentive for Fred or Harry to chisel on the contract Fred may find that although he is “better off” materially by agreeing to property rights than he is by remaining in a state of anarchy, he may be even “better off” by

violating the agreed-upon rights of the other Through stealing, or in other ways violating Harry’s rights, Fred can redistribute the total wealth of the community toward himself

To illustrate, consider Figure 1.2, which contains a chart or matrix of Fred and Harry’s utility (or satisfaction) levels if either respects or fails to respect the rights

established for each as a part of the contract (The actual utility levels are hypothetical but serve the purpose of illustrating a basic point.) There are four cells in the matrix, representing the four combinations of actions that Fred and Harry can take They can both respect the agreed-upon rights of the other (cell 1), or they can both violate each other’s rights (cell 4) Alternatively, Harry can respect Fred’s rights while Fred violates Harry’s rights (cell 3), or vice versa (cell 2)

Clearly, by the utility levels indicated in cells 1 and 4, Fred and Harry are both better off by respecting each other’s rights than by violating them However, if Harry respects Fred’s rights and Fred fails to reciprocate, Fred has a utility level of 18 utils, which is greater than he will receive in cell 1, that is, by going along with Harry and respecting the other’s rights Harry is similarly better off if he violates Fred’s rights while Fred respects Harry’s rights: Harry has a utility level of 16, whereas he will have a utility level of 10 utils if he and Fred respect each other’s rights The lesson to be

learned: Inherent in an agreement over property rights is the possibility for each person to gain by violating the rights of the other If both follow this course, they both will end up

in cell 4, that is, back in the state of anarchy

Figure 1.2 The payoffs (measured in “util” terms)

from Fred and/or Harry either respecting or

violating the other’s rights are indicated in the four

cells of the matrix Each has an incentive to violate

the other’s rights If they do violate each other’s

rights, they will end up in cell 4, the worst of all

possible states for both of them The productivity

of the “social contract” can be measured by the

increase in Fred and Harry’s utility resulting from

their moving from cell 4, the “state of nature,” to

cell 1, a state in which a social contract is agreed

upon

11

Locke, The Second Treatise, p 32

There are two reasons why this may happen First, as we stated above, both Fred and Harry may violate each other’s rights in order to improve their own positions; the

action may be strictly offensive By the same token, each must consider what the other

will do Neither would want to be caught upholding the agreement while the other one violates it If Fred thinks Harry may violate his rights, Fred may follow suit and violate Harry’s rights: he will be better off in cell 4, i.e., anarchy, than in cell 2 Fred and Harry

can wind up in anarchy for purely defensive reasons Many wars and battles, both at the

street and international levels, have been fought because one party was afraid the other would attack first in order to get the upper hand The same problem is basically involved

in our analysis of the fragile nature of Fred and Harry’s social contract

Fred and Harry’s situation is a classic example of what social scientists call a

“prisoner’s dilemma.” The name comes from a standard technique of interrogation

employed by police to obtain confessions from two or more suspected partners to a

crime If the method is used, the suspects are taken to different rooms for questioning, and each is offered a lighter sentence if he confesses But each will also be warned that if the other suspect confesses and he does not, his sentence will be more stringent The suspect has to try to figure out, without the benefit of communication, how the other will stand up to that kind of pressure Each may worry that the other will confess and may confess because he cannot trust his partner not to take the easy way out.12 The problem that the individual suspect becomes more complicated when the larger the number of partners to the crime who are caught with the individual increases There are more

people upon whom he must count to hold up under the pressure, which he knows is being brought to bear He must also consider the fact that the others may confess because they cannot count on all partners to hold under the pressure

To prevent violations, both of offensive and of defensive nature, a community may agree to the establishment of a police, court, and penal system to protect the rights specified in the social contract The system may be costly, but the drain on its total

wealth may be smaller than if it reverts back to anarchy, in which case resources will be diverted into predatory and defensive behavior The costs associated with making the contract and enforcing it will determine just how extensive the contract will be, and this matter will be considered later in a separate chapter; that for now, assuming the benefits from the contract exceed the costs of contracting and enforcement, we may summarize the foregoing discussion in terms of Figure 1.3 In the state of nature, Fred and Harry, through allocating their resources among productive, predatory, and defensive uses, will achieve a certain level of welfare In terms of Figure 1.3, Fred achieves an initial utility

level of U F1 and Harry, U H1 By developing a social contract, through which they define

and enforce property rights, each can move to a higher utility level; Fred to U F2 and

Harry to U H2 With social contracts, they both can move to higher utility levels because they no longer have to divert their resources to predatory and defensive actions

12

There is no wonder that prisoners have such harsh feelings toward those who cave in and “rat on them”

or “fink out.”

The Emergence of Exchange

The social contract, which defines property rights, establishes only the limits of

permissible behavior; it does not mean that Fred and Harry will be satisfied with the property rights they have been given through the contract To the degree that some other combination will give them more satisfaction, exchanges can emerge, provided, of

course, that the social contract permits them In terms of Figure 1.3, they can, through

exchanges or trades, increase their utility to U F3 and U H3

Figure 1.3 In the “state of nature,” in which Fred

and Harry each has to use resources to fend off the

other, the welfare of Fred and Harry are,

respectively, UF1 and UH1, or point N A social

contract can move them both to point C They can

further improve their welfare by trading the

“rights” to goods and services that they are given in

the social contract

For example, suppose that the only goods on Fred and Harry’s island are coconuts and papaya s The social contract specifies the division of the fruits between them We need not concern ourselves with the total number of the fruit each has; we need only indicate the relative satisfaction that Fred and Harry receive from the marginal units Suppose the marginal utilities in the table below represent the satisfaction they received from the last coconut and papaya in their possession:

In the illustration, Fred receives more utility from the last papaya (15 utils) than from the last coconut (10 utils) He would be on a higher level of utility if he could trade

a coconut for a papaya He would lose 10 utils from the coconut but would more than regain that with the additional papaya On the other hand, Harry receives more utility from the last coconut than from the last papaya He would gladly give up a papaya for a coconut; he would be 60 utils of satisfaction better off (90 minus 30) than if he did not

engage in the exchange The two should continue to exchange rights to the coconuts and

papayas until one or both of them can no longer gain via trade

In this example, we are not concerned with production of coconuts and papayas;

we are concerned merely with the benefits from trade resulting from the initial allotments

of the fruits The trades are comparable to those that took place in the prisoner-of-war camps as described by R.A Radford (See the first few pages of this text.) If the social

contract allocates to Fred and Harry rights to produce the fruit, we can also demonstrate

that both can be better off through specializing in their production and trading with each other Consider the information in the following table; it indicates how many coconuts or papayas Fred and Harry can produce with, say, one hour of labor:

Coconut Production

Papaya Production

In one hour of labor Fred can produce either 4 coconuts or 8 papayas; Harry can produce either 6 coconuts or 24 papayas Even though Harry is more productive in both lines of work, we can show that they both can gain by specializing and trading with each other

If Fred produces 4 coconuts, he cannot use that hour of time to produce the 8 papayas In other words, the cost of the 4 coconuts is 8 papayas, or, what amounts to the same thing, the cost of 1 coconut is 2 papayas Fred would be better off if he could trade

1 coconut for more than 2 papayas, because that is what he has to give up in order to

produce the coconut To determine whether there is a basis for trade, we must explore the cost of coconuts and papayas to Harry We note that the cost of 1 coconut to Harry is

4 papayas; this is because he has to give up 24 papayas to produce 6 coconuts If Harry could give up less than 4 papayas for a coconut, he would be better off He could

produce the 4 papayas; and if he has to give up fewer than that for a coconut, he will have papayas left over to eat, which he would not have had without the opportunity to trade

To summarize: Fred would be better off if he could get more than 2 papayas for a coconut; Harry would be better off if he could give up fewer than 4 papayas for a

coconut If, for example, they agree to trade at the exchange rate of 1 coconut for 3 papayas, both would be better off Fred will produce a coconut, giving up 2 papayas, but

he can turn around and get 3 papayas for the coconut Hence, he is better off Harry can produce 4 papayas, giving up 1 coconut, and trade 3 of the papayas for a coconut He has the same number of coconuts, but has an additional papaya Harry is better off

Although relatively simple, the above example of exchange is one of economists’ most important contributions to discussions of social interaction So many people seem

to think that when people trade, one person must gain at the expense of another If

people in the United States trade with people in Japan, someone must be made worse off

in the process, or so the argument goes We will deal with such arguments in more detail