Property rights versus liability rules

A property right endows the owner with the right to use, exclude or dispose of an economic asset. A liability rule, on the other hand, does not create a right to exclude another from using a resource. Instead, as we have seen in Chapter 4, a liability rule creates a right to claim damages for certain injuries to a resource. That is, liability rules state the conditions under which the 'injurer' is legally obligated to make a monetary transfer to the 'victim'.

Often property rights and liability rules coexist on the same economic asset. For example, on the one hand, individual A may enjoy a property right over a car - individual B cannot transfer the right to use the car the car from A simply by taking it and then paying compensation for damages to A in court. On the other hand, although A's right to the car may be absolute against attempted takings by private individuals, it may only be a qualified right against the government, which may be legally able take A's car for public use, subject only to having to pay individual A a 'fair' value for the car. Thus A may enjoy a property right against B, but may only enjoy a liability rule against the government.

How should we distinguish between property rights and liability rules? One useful way is to distinguish the two by referring to the legal remedy that is available to a prospective or actual victim. This is done as follows:

  • • If a party has a right to enjoin (prevent) the injury-causing conduct, then the person can be said to have a property right, since the threat of the injunction should deter a potential injurer from seeking to appropriate the right without negotiating with the owner and obtaining the owner's consent.
  • • If a party only has a right to compensatory damages, then he is only protected by a liability rule, because anyone who is prepared to pay the cost of injury to the victim will not be deterred from inflicting damage, and will not bother to negotiate with the owner and obtain the owner's consent.

The key distinction is in terms of consent or voluntary transactions. Because accidents are usually only probabilistic externalities, torts and liability rules involve non-voluntary transfers of wealth between victims and injurers. In other words, in certain circumstances a liability rule allows resources to be transferred from the victim to the injurer (or vice versa) without the victim's (or injurer's) consent.

On the other hand, the transfer of a property right requires the owner's consent to the transfer; this requirement prevents one person from taking something belonging to another, even if it is shown that the thing is worth more to him than the owner. In other words, property rights channel transactions away from the legal system and into the market (voluntary transactions), whereas liability rules allow transactions to be made via the legal system, bypassing markets.

Ideally, which factors should determine whether a person should hold a property right or a liability rule? The classic answer to this question can be found by analysing transaction costs. When the costs of arranging voluntary transactions are low enough, then the property right approach is economically preferable to the liability rule approach, because, in general, markets are a more reliable register of values than the legal system. On the other hand, when transaction costs are high enough, the property right approach is inferior, because the requirement of consent and voluntary transfer will prevent resources from being shifted to their most valuable uses. In an efficient legal system, property rights will be used in settings of relatively low transaction costs, and liability rules will be used in settings of relatively high transaction costs.

The transaction cost analysis of property rights versus liability rules is best illustrated by returning to the framework studied in Chapter 4.

Consider Figure 7.2.1. In this figure the amount of production (and pollution) is measured from right to left, beginning at the point OF, which is the factory's origin.

Suppose that the residents enjoy a property right over clean air, which means that the factory cannot produce without first obtaining the residents' explicit consent, irrespective of how much the factory is willing to compensate the residents. The starting point for any negotiations is therefore OF. In the absence of transaction costs the outcome under a property right would be QLR, where all possible gains from trade (A + B + C + D) are exhausted.

However, if there are transaction costs equal to $t per unit traded, then the outcome under a property right is QPR, where the marginal gains from trade are equal to the marginal transaction costs. This is not only inefficient in the usual sense (resulting in a welfare loss of A), but because of the transaction costs that the parties incur, the gains from trade are only C + D. The area B is not gained by the parties as a result of the costs of transacting. A property right here results in welfare gains of C + D relative to the no-trade situation.

Property rights and transaction costs

Figure 7.2.1 Property rights and transaction costs

On the other hand, if the residents only enjoy a liability rule, they must be compensated for damages from pollution - but if damages are computed accurately and fully compensate them for harm, then this will leave them no better off nor worse off than they were before the factory emitted any smoke. The factory would produce smoke up to the point at which their marginal benefit equals the marginal compensation paid to the residents. This occurs at point QLR. The factory would pay the residents the loss in benefits, which is E + F + G, and the residents would remain no worse off, whilst the factory would gain (A + B + C + D + E + F + G), for a net gain of (A + B + C + D).

Naturally, the residents prefer the property right to the liability rule, since even in a world of high transaction costs the former arrangement gives them a net gain of C, whereas the liability rule gives them a net gain of zero. Conversely, the factory would prefer a liability rule, since this gives them a net gain of (A + B + C + D), whereas the property right in a world of high transaction costs gives them a net gain of D.

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