Overlapping disposal rights

The previous section showed how welfare losses can occur as a result of overlapping or multiple usage and exclusion rights. But even if these problems can be avoided, welfare losses can also occur as a result of overlapping disposal rights to an asset.

A large number of atomistic owners with overlapping disposal rights

We view disposal rights as the right to transfer control of the resource to another party. To understand the nature of overlapping disposal rights, let us consider an example from corporate law. Suppose that there is an asset that is owned by a very large number of small or 'atomistic' shareholders, each of whom owns a very small fraction of the asset. The shareholders supply capital but do not have the skills or expertise to manage the asset, so they employ a manager. The manager charges the optimal usage price as discussed above, and so maximises the benefits of the asset's sustainable extraction rate and the asset's economic value, given his skills and expertise. Suppose the current (market) price of a share is PS, and the market value of the asset is B(N*).

Suppose that there is a 'raider' who has superior management skills who would fire the current management team and increase the value of each share to V > PS, which they could do if they owned at least 50 per cent of the shares. Suppose that the raider offers a price per share of PR, where PS < PR < V. Efficiency dictates that the raider acquire the shares, since the value of the asset increases as a result of this transaction.

Shareholders have a simple decision here: they can either tender (that is, sell) their shares to the raider, or not. Because there are many individual shareholders, each shareholder's tender decision has a minuscule effect on the likelihood of the takeover bid succeeding. In other words, the probability of a shareholder being pivotal and affecting the outcome is negligible.

Under these conditions, consider the payoff to each very small shareholder from tendering (selling) his shares to the raider. Suppose that a shareholder believes that the takeover will succeed. The payoff from tendering shares is then PR, but the payoff from not tendering is V > PR. Thus the shareholder would not tender his shares. But this means that no shareholders will tender. Grossman and Hart (1980) therefore argue that the takeover bid will fail, and the potential welfare gain of V - P will not be realised. The reason for this inefficiency is straightforward: each shareholder has a negligible effect on the probability that the takeover will succeed, so each has an incentive to free ride on the success of the takeover. The takeover will only succeed if PR > V, which would result in a loss to the raider.

Why does this inefficiency occur? The reason is the overlapping disposal rights of shareholders, combined with the legal rule which states that the raider must acquire at least 50 per cent of the shares before he can take control. These institutional arrangements around control rights and disposal mean that each shareholder exerts an uncompensated economic benefit on his fellow shareholders if he tenders his shares. Since the benefit is uncompensated, private marginal benefit of tendering is less than the social marginal benefit of tendering. There is an incentive for free-riding. As the number of shareholders rises, the incentive for free-riding becomes greater.

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