How to Correct Market Frictions and Failures By Weakening Property Rights

Although economists have long maintained that weak property rights are detrimental for economic development since they discourage trade and innovation, private parties are regularly allowed to directly or indirectly take private property, notwithstanding the remedies available to dispossessed owners. In a recent paper, I show, both theoretically and empirically, that such legalized private takings are optimal when market frictions and failures prevent consensual exchange of economic value and/or innovation activities.

A paradigmatic example of direct legal expropriation is that of adverse possession, whereby a good faith buyer acquires, as a result of the passage of time, ownership of a good stolen (embezzled) from its original owner (a principal) by an intermediary (agent). Similar cases include: a squatter successfully occupying a house; an agent providing a service that she is not allowed to offer; a downstream firm obtaining the compulsory licensing of an excessively expensive upstream firm’s intellectual property; a manager favoring majority stakeholders by tunneling minority shareholders’ and creditors’ resources out of a firm; an intermediary double pledging collateral; and a principal segmenting a labor, financial, or housing market. A key instance of indirect legal expropriation is the seizure by the state of real private property, with the aim of transferring it to a private party for private for-profit use. In all these cases, the legal system decides that, because of large transaction costs, a private party can keep another private party’s property after having expropriated it.

To formalize this idea, I study both the possibly consensual exchange of economic value between its original owner and a potential buyer, and a downstream firm's choice of whether to produce in-house through an old technology or to adopt a new one necessitating an upstream firm's input.

Consider first the choice of the original owner’s property rights. When they are fully protected, some high-valuation potential buyers are inefficiently excluded from trade because of the wasteful transaction costs they need to pay, in addition to the original owners’ valuation, to acquire the asset. When instead the original owner’s property rights are weak, and thus the probability that an expropriated asset would be given back to its original owner is lower than one, inefficient exclusion from trade is partly solved, but low-valuation potential buyers inefficiently expropriate the original owners. Hence, a rise in transaction costs has: (1) the marginal effect of inefficiently pushing some high-valuation potential buyers to expropriate the asset; and (2) the infra-marginal effect of decreasing the payoff of the remaining high-valuation potential buyers who continue to buy. Therefore, rising transaction costs must also reduce the protection of the original owner’s property rights and, in turn, the size of the market. This pattern holds true regardless of whether transaction costs are driven by frictions outside the control of traders—e.g., financial inefficiencies—or endogenously determined by the original owners' market power and/or their privileged information.

Next, consider the design of the upstream firms’ property rights. If these are strong, the risk of being held-up discourages the downstream firms from innovating. When they are weak, low-productivity downstream firms inefficiently exploit the input. Balancing these misallocations of the upstream firm’s input entails that property rights will be weaker, and innovation more intense, the larger asset specificities are. Then indeed, the upstream firms will gain a larger expected rent from holding-up the downstream firms, and thus they will require a lower legal protection to provide the input.

These implications survive when a group of traders/innovators has a larger political influence on institutional design, and when the disincentive effect of weak property rights is considered. In addition, they are consistent with the negative effects of proxies for market frictions—i.e., excessive regulation and financial inefficiencies—and failures—i.e., lack of competitiveness of corporate activity, lemons-type distortions, and asset specificities—on measures of the protection of the original owners’ and upstream firms’ personal, intellectual, and financial property for a panel of 135 countries spanning the 2006-2015 period. Crucially, these patterns entail that the negative link between weak property rights and outcomes highlighted by the economic development literature might be driven by the mere fact that the former are typical of large-transaction costs jurisdictions.

This conclusion collides with the Washington consensus, according to which economic development is always favored by a stronger protection of property from predation by the state and powerful elites. There are two obvious inconsistencies between this argument and the results just illustrated. First, predation is a particularly tight constraint only for developing countries in times of conflicts, whereas private takings are ubiquitous forms of welfare-enhancing expropriation that occur daily within the rule of law. Second, imperfections in the political process can produce not only too weak but also too strong original owners’ (upstream firms’) property rights, depending on who between potential buyers and original owners (downstream and upstream firms) prevail in the political arena.

All in all, this line of research suggests that understanding more deeply how market conditions determine the distribution of property rights is necessary to help law practitioners, managers, and investors figure out the structure of the environments in which they operate or in which they wish to enter, and therefore plan effectively their production, investment, and even outsourcing decisions.

Carmine Guerriero is the "Rita Levi-Montalcini" Untenured Associate Professor at the University of Bologna.