by Filip Palda
In a celebrated article entitled Toward a Theory of Property Rights, Harold Demsetz argued that property rights come about as the result of cost-benefit calculations. Serfdom in Europe was once a form of slavery from which there was no escape. This was a constricting situation for both sides because the serf might have been more productive working as a merchant in a large town. However, the serf was not able to cut a deal with the lord because there were no courts or police that could guarantee that the former serf would pay his debt to the lord after moving away and starting his new profession. Eventually laws and an enforcement apparatus evolved that allowed serfs to buy their freedom by credibly promising their lords payments out of their future free wages.
The evolution of laws and enforcement was the force that drove down the cost of establishing the human property rights over which serfs and lords could bargain. Demsetz provided other historical examples to support his contention that the costs of creating property rights need to be compared to the benefits they generate before a verdict can be reached about relying on them. His conclusion was that once the results on performance are in, we may find that property rights are not the best way to resolve every conflict over the use of resources.
Demsetz’s work followed on from insights by a young economist plying his trade in London in the 1930s. Nobel Prize winning economist Ronald Coase demonstrated in a 1937 article entitled The Nature of the Firm that firms balance the benefits of property rights against their costs. Corporations do not rely on decentralized bargaining over property rights among their employees to get things done, but rather on vertical lines of command and cooperation. Bosses give broad indications of how the corporation’s resources are to be used and office workers fill in the gaps by cooperating with each other. Corporations work this way because it is not efficient for every exchange between people to be done for money.
Think of how long it would take to build a skyscraper if all workers were independent bargainers who had to write individual contracts with all other workers. Who can borrow Martin’s arc welder and at what price, and how much shall we all pay for the administrative services of Drusilla, would be two of the hundreds of thousands of contracts that would have to be written. It is far more effective for workers and administrators to band together in a firm where the only contracts are the salary paid for a job well done, and the fee charged the customer. These contracts are convenient shorthand for resolving the multitude of conflicts that go into any sort of grand collective enterprise. Even though they appear as flagships of the capitalist system of money and trade, below decks corporations strive to be sharing communities. In a sense, the corporation is a return to an earlier social condition in which the Golden Rule of exact reciprocity applied and in which the costly instrument of property rights was not needed to resolve disputes.
Enter government
In the case of society, just as in the case of firms, sometimes property rights are too costly to pay for and a hierarchical solution to conflicts is required. Consider a coal-powered electricity plant that spews sulphur into the air. The plant and its customers are happy to do business, but they are violating Pareto efficiency by producing acid rain, which destroys gardens and private forests and thereby violates other people’s claims to their own property. It may be too costly for the victims to prove the damage that is being done to them and seek court-ordained compensation. In other words, defining and enforcing property rights to clean air may be impossible. Some economists call this situation “market failure.” In the next chapter I explain why market failure is exclusively a failure to define property rights and how this is the only reason in Pareto’s Republic for government action.
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In the early twentieth century, economists started thinking about Pareto efficiency with only a vague notion that it would lead to a coherent view of government’s role in society. Gradually it dawned upon them that when some basic principle is suggested on which interactions between people can be based, or some basic assumption about human nature can be deduced, advice on government’s role in society usually, but not always, follows.
The basic assumption about human nature in Pareto’s Republic is that people ceaselessly seek out their private interest. The principle upon which they act to maximize this interest is the exchange of private property rights. So why do we need government in the Republic?
In Pareto’s Republic government may need to intervene when individuals, acting on their own initiative, are unable to create systems of property rights that impartially help to resolve disputes over how resources should be used. In simple language, people may need an umpire to enforce the rules of the property rights “game” impartially because some may be tempted to play dirty and settle things by force rather than by offering money.
That umpire is called government. In practice and theory, government is that institution in society which holds a monopoly on coercive force. Since Pareto’s Republic is based on property rights, the most basic function of government is to protect these rights by suppressing expressions of force by private individuals. This is the meaning of rule of law, and as we saw in the previous chapter, if the law is allowed to favour some over others, then force rather than agreement can become the determining factor in social accounting. When this happens, social accounts can fall seriously out of balance.
Even with a government ready to enforce the law of property evenly, there may be cases in which it is simply impossible to assign property. How do you give someone the exclusive right over a school of fish that may roam the ocean in complete ignorance that they belong to a human? Then there are the great projects that benefit everyone, but for which no entrepreneur could charge. If you lit public streets with lamps, how would you charge passersby for the service? Fish cannot be assigned to an owner nor can one charge for street lighting. In such cases great projects will fail to get off the ground, and people will either overexploit an open natural resource or fight each other over it. Without property rights to act as a peaceful and productive dispute resolution mechanism, some sort of official coercion might be needed to put a cap on the disagreements that arise. Submitting to government is unpleasant, but allowing private individuals to resolve their differences by force can produce a state of anarchy.
Here, then, is a possible justification for government in Pareto’s Republic: to resolve disputes where property rights cannot be established and exchanged in a private market. This chapter explains that in fact this is the only justification for government. This may sound narrow and blinkered. What about help for the poor, public health care, or education for those who cannot afford it? To answer this challenge we must broaden our understanding of what property is. We will see that there are two instances in which private disputes over resources cannot be resolved peacefully between individuals. This is the case when resources belong to a common property pool such as an ocean fishery. In such cases, it is impossible to control the overexploitation of the resource by peaceful agreements between individuals. We will also see that individuals may fail to band together in great projects, known as public goods, that benefit all because it is impossible to stop some from shirking their responsibility to contribute to the project and thus “poach” on the investment others may make.
We will reach two conclusions. First, care for the poor and many other forms of government intervention we consider to be worthy on their own merits may be justified on the grounds that property rights have failed. Government may step in to produce levels of public service that simulate a Pareto-efficient outcome. Second, we will see that government should never try to hold on to any of its functions for too long. Progress in technology makes it possible in ways never before imagined to establish new private property rights. When such an advance occurs, government should abandon its stewardship of the resource in question.
The two reasons property rights fail
As previously mentioned, there are two circumstances in which property rights fail. One circumstance is the existence of
a very strange sort of resource known as a “public good.” (This is not to be confused with the public good.) A second circumstance is called “the tragedy of the commons.” These two exceptions to property rights, and only these two, can undermine the peaceful, Pareto-efficient resolution of disputes. Understanding how these two circumstances challenge property rights and devising countermeasures that bring us back to Pareto efficiency was largely the work of three thinkers. In a four-page essay from 1954, Nobel Prize winning economist Paul Samuelson came up with a mathematical formula that could precisely answer how much of a public good government should provide to attain Pareto efficiency. This precision was at that time quite new in the social sciences. All previous attempts by intellectuals to define government’s role dealt with generalities and left the decisions about the amount to spend to the discretion of the party or of enlightened leaders.
What distinguished Samuelson’s formula from earlier thinking was not the brilliance of the analysis, but a practical proposition on how to put his idea into practice. Nicholas Kaldor and John Hicks discovered a principle showing how to convert the Samuelson formula into a workable plan consistent with Pareto optimality. Samuelson’s formula needed conversion because as we shall see, on its own, it had the potential to be a tool for oppression. At around the same time as Samuelson was coming up with his formula, Garret Hardin was raising the alarm over something he called the tragedy of the commons. Hardin’s essay of the same name signaled the dangers of not establishing private property rights over natural resources and became one of the most quoted academic articles of the 20th century.
Unfortunately, as in so many cases of intellectual genius, someone had already come up with Hardin’s idea. That someone was H. Scott Gordon. Here is not the place to dwell on this controversy, but rather to understand how the insights of Samuelson, and Gordon and Hardin, led to the first scientific justification for the government’s quest to create a Pareto-efficient society, and how in so doing, this quest also showed how to draw a precise line dividing private initiative from legitimate government coercion.
Public goods
I indicated at the start of this chapter that government should intervene in the name of Pareto efficiency where the forum for agreement over property rights breaks down. This breakdown is evident in the case of so-called public goods. Economists define a public good as one that you and I must consume together in a non-rivalrous manner, and from whose consumption neither of us may be excluded. In economic jargon, public goods are non-rivalrous and non-excludable. As with many economic definitions meant for the specialist, to make sense, this one calls for a few examples.
We take night life in the streets for granted, but until the 19th century, dark was a time to slam the dead bolts shut and cower in bed. The Gentleman’s Magazine, a publication popular in the 1700s for its eclectic mix of current events, science, and poetry, summarized the general feeling with the statement, “dark was the night, it was that hour, when terror reigns in fullest power. When, as the learned of old have said, the yawning grave gives up her dead.” This was a slight exaggeration perhaps, but one that conveyed the fear of crime that rose as the sun fell. With the discovery of how to turn coal into a combustible gas in the early 1800s, illuminating streets became feasible, yet the promise this offered of banishing fear from the streets at night remained elusive. Companies supplied gas to factories and private properties that could be metered, but gas lamps were largely absent from city streets. With the exception of burglars, most people would have benefited from lighting and would have been willing to pay something for the service. Private firms did not provide lighting to public areas because they had no way to collect money from the person walking through a public street at three o’clock in the morning. This was a shame because street lighting had a remarkable quality. What any one person consumed did not detract from another’s consumption. Once a system of street lights was built, one person or a thousand people could enjoy it without any change in one person’s consumption. Street lighting offered society a service that all could consume without rivalry or argument. Private goods, in contrast, are rivalrous. What I consume of them reduces what you may consume. A sandwich is rivalrous because every bite I take means a bite less for you. No such conflict arises with street lighting.
Another example of a public good is the legal “infrastructure” that secures property rights. By definition, secure property rights can have only one protector. A property rights regime that guarantees Pareto-efficient peace cannot be “consumed locally,” that is, different laws cannot apply to different individuals concerning the same property. If there were to be a different law for each person, then local property rights would be just a fancy term for the arbitrary use of force to settle disputes over resources. For a property rights regime to work efficiently, it must work “globally,” that is, be applied equally to all. This idea of global application is the cornerstone of the rule of law. The property rights regime that emerges from the rule of law spreads its benefits indivisibly on all. Living in a society that has secure property rights is like walking along a well-lit street at night. The glow is not diminished by the presence of an extra walker.
Prisoner’s dilemma
That a good is consumed without rivalry, as is the case with street lighting, is not a sufficient reason for government to intervene in its production or distribution. People who watch a movie in the theatre do so jointly, each without detracting from the consumption of another (unless excessively high headwear is involved). There seems to be no problem with having the private sector provide this service. Street lighting, on the other hand, is a candidate for government attention because, for technological reasons, or because of constitutional guarantees of privacy, it is not possible to track people in the streets and send them a bill for their presence there at night.
When people are not obliged to pay directly for a service or good, a “free-rider” mentality may develop and the funds needed to maintain the service may dry up, much to the detriment of all, including those who free rode. The free-rider mentality develops because of a phenomenon known as the prisoner’s dilemma. The origins of the term are not important. What the dilemma describes are situations in which people who follow their personal interests end up producing collective calamities that serve no one. If street lighting depended on voluntary contributions then the individual following his or her best interest would reason as follows. If I free-ride on the funding of others, I will enjoy the street lighting but will not have paid for it. Conversely, if I believe no one else will contribute to the fund, there is also no point in me spending my money. So no matter what the strategy of other “players” in this game, my best strategy is not to contribute and hope that if the project gets built, I will get a free ride. This type of thinking cascades until the burden on remaining individuals willing to give charitably may be such that the street lighting project founders. The irony here is that everyone is worse off in this case than if they could have found some means of all binding themselves to giving to the fund.
Public goods are sometimes in short supply due to free riders, but there are exceptions. If a sufficient number of people are united in a charitable enterprise, they will not reason as free riders and will voluntarily band together to get the big jobs done. Voluntary donations of money and effort by members of every social standing built the gothic cathedral of Chartres. In his book Civilization, Kenneth Clarke describes how both high-born ladies and charwomen carried stones on their backs for miles to be set before master craftsmen working on what was then and remains a miracle of architecture. The tradition of charity among all economic classes in the West continues to this day and constitutes an important part of modern economies.
Yet despite the powerful expressions of charity in today’s society, the very size of that society gives rise to the threat that free riding will be a problem that may stop the really big jobs from getting done. As mentioned recently, the foundering of collective effort due to free riding is one va
riant of what game theorists call the prisoner’s dilemma. The dilemma exists when an individual does not have either law or custom to help him or her bond with others in mutually beneficial agreements. In the absence of such bonds, the logic of personal greed leads to a collective breakdown which leaves everyone worse off than if they had cooperated. Government can prevent this breakdown by forcing us to pay the taxes needed to get the public goods projects built.
The idea that government has the power to coerce us sounds sinister, but in the case of public goods, everyone agrees to be coerced so that they can escape the prisoner’s dilemma and enjoy the fruits of collective action. A folk tale in economics illustrates the point. Cruising down China’s Yangtze River in the 1920s, a Western woman observed a barge being towed by men struggling on the embankment under the ministrations of a whip-yielding headman. “I thought you had done away with slavery,” the tourist commented to her guide, to which he responded, “Madam, they are not slaves, but rather the employers of the whip master.” To ensure that all pulled their weight, the men hired a supervisor to goad them into putting equal effort into pulling their jointly owned barge up the river. What we must not forget in telling this story is that the men towing the barge had a variety of whip masters to choose from. For governments to provide public goods without abusing their coercive powers, public choice of government is also needed, as will be illustrated with greater precision in this and following chapters.
