When Are Weak Property Rights Optimal?

By Carmine Guerriero (University of Bologna)

While economists have long maintained that weak property rights are detrimental for development since they discourage effort and investment (Besley and Ghatak, 2010), legal scholars have argued instead that they can be optimal whenever transaction costs prevent consensual trade (Calabresi and Melamed, 1972). In my paper Endogenous Property Rights, forthcoming at the Journal of Law and Economics, I blend these two opposing ideas and I empirically document both the general incompleteness of property rights and their positive relationships with several measures of preference heterogeneity in 126 jurisdictions.

While all legal systems punish illegal private takings and provide remedies for dispossessed original owners, private parties are often allowed to directly or indirectly take private property whenever transaction costs are sizeable (Bouckaert and De Geest, 1995). An example of direct legal expropriation is adverse possession, which is the acquisition by a good-faith possessor of property rights by virtue of the passing of time and recurring other conditions such as open and continuous possession. A case of indirect legal expropriation is instead the possibility for the state to seize real property from a private party to transfer it to another private party for private for-profit use and under power of eminent domain.

To rationalize these instances and provide a framework to analyze other importance cases relevant for example for financial intermediation, I study a simple, and yet general, economy. Society is equally split into original owners, who have the same valuation for an economic value, and potential buyers, who have instead heterogeneous valuations. The former are randomly matched to the latter by an intermediation technology that allows each potential buyer to either obtain the good via consensual transfer by paying the original owner’s valuation and bearing a socially wasteful transaction cost—that is, credit, trading, or legal expenses—or expropriate it at no cost. I define property rights as the probability that an expropriated good is given back to its original owner. This captures the idea that the stronger are the remedies in the original owner’s hands and the longer is the period a good-faith possessor needs to acquire ownership the higher are the odds that the original owner will be protected after expropriation.

When property is fully protected, then some potential buyers with valuation higher than that of original owners are inefficiently excluded from trade due to transaction costs. When the protection of property is instead weak, low-valuation potential buyers inefficiently expropriate original owners. A rise in the heterogeneity of the potential buyers’ valuations makes inefficient expropriation by low-valuation potential buyers weigh on the social welfare more heavily than inefficient exclusion from trade and therefore induces stronger property rights.This prediction survives if institutional design is not completely democratic since it excludes some potential buyers from policy-making, when the transaction cost is endogenously determined by either market power or asymmetric information, when the potential buyers need to pay damages to keep a successfully expropriated good, when the original owners have heterogeneous valuations, when both groups can bargain over the price, when expropriation is costly, and if one considers production and investment activities.

To evaluate the central implication of the model, I look at the relationships between measures of ethno-linguistic, genetic, and religious diversity, which, according to a large literature in population genetics, proxy preference heterogeneity (Cavalli-Sforza et al., 1994), and novel data on the rules on adverse possession and on government takings of real property in 126 jurisdictions. This dataset, which Giuseppe Dari-Mattiacci and I assembled by sending questionnaires to leading legal experts, measures the extent of protection of property from legal direct and indirect private takings. This is different from the predation by the state and the elites, which is much less common but has been the focus of the extant literature. OLS estimates suggest that the protection of the original owners’ property rights is the strongest where the extent of preference diversity is the largest. Evidence from several identification strategies implies that this relationship is causal. In addition, my measures of property rights correlate weakly and possibly negatively with the most-used predation-based proxies for property rights. Hence, a key issue for future research is to evaluate the relationships among “horizontal property rights,” the “vertical property rights” defending the citizenry from predation by the state and the elites and analyzed by the extant literature, and the economy.

Finally, another crucial avenue for further analysis is to use my model to understand other crucial legal issues as those related to financial intermediation. Two glaring examples are bankruptcy law and segmented financial markets. For what concerns the former case, the original owner-potential buyer tension can be reinterpreted as the one between a creditor and a shareholder who “tunnels” resources out of a firm. My framework suggests that this looting of firms by the controlling shareholders should be legally forbidden especially when the shareholders’ valuation of the firm’s assets is sufficiently heterogeneous and when the transaction costs of liquidation and restructuring procedures are limited (Johnson et al., 2000). Similarly, the conflict between original owners and potential buyers can be seen as the one setting an agent against her principal in a segmented financial market. This second application is particularly useful to clarify how to spur growth in those developing countries where huge transaction barriers—political and legal risks, currency uncertainty, and trading costs—segment equity markets, thereby driving away foreign investments and depriving local citizens of the ability to diversify their wealth and to invest their savings overseas.

The full paper is available for download here. This blog post first appeared at the Harvard Law School Forum on Corporate Governance and Financial Regulation.

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