Property rights and externalities

The invisible hand result assumes that all goods and services and factors of production are privately owned, and that property and other legal rights and obligations (including contractual rights) are well defined and enforced. In other words, the invisible hand result assumes that there is a legal system in place which defines and enforces these rights and obligations. The main purpose of this book is to explain why this set of assumptions matters so much and why legal rules play such an important role in market economies. Chapter 7, for example, explores in detail why the assumption of well-defined private property rights matters for efficiency.

Suppose that in the model of the perfectly competitive market examined above, there are no private property rights over one of the factors of production that are used by firms to produce output. Specifically, suppose that land, which we assume to be a key input, is not privately owned, but is instead able to be accessed without cost by each firm in the industry. In contrast, private property rights typically include a right to exclude others. Land is scarce, and when each firm in this hypothetical industry uses land and there are no private property rights, this imposes an unpriced cost on the other firms. In the language of economics, firms impose a negative externality on each other. Competition will result in a situation where the marginal willingness to pay for land is far below its opportunity cost, and the land will be inefficiently overused. The invisible hand theorem fails in this instance not because of competition and markets, but because of an absence of private property rights over some goods or services.

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