PROPERTY RIGHTS

Lecture 5: Support and Attenuation of Property Rights by Government

Authors: Richard L. Stroup and Charles N. Steele

•  Regulation: when does it strengthen property rights? (Barzel, Ryan)
•  Taxation to support government.
•  Taxation to support redistribution.
•  Limits on contract.

Introduction

This lecture addresses the attenuation of property rights. An attenuation of a property right is a restriction placed on the use or transfer of property. Such restrictions can even include transferring a right from one party to another. Hence, the study of attenuation of property rights is the study of the boundaries and definitions of rights. Why are certain limits placed voluntarily by owners on their existing rights, and what are the likely consequences of those limits? What happens when the property rights to a resource are partitioned�divided among multiple owners? Barzel (2000), (Norton, 1998) and others have fruitfully discussed these questions. This lecture reflects certain aspects of their work.

The attenuation of property rights can be divided into two categories: restrictions can be mutually agreeable to all parties involved, or they can be imposed against the will of one or more owners. Attenuation of property rights can in some cases enhance property rights, raising the value owners derive from property; in other cases these restrictions can reduce the value of property. Government is frequently � although not always � the means of enforcing restrictions on property rights. This lecture begins with a general analysis of attenuation of property rights. It then addresses government restrictions on property rights, including regulation, taxation, and limitations on contract.

As we have seen in previous lectures, a property right is an ability to hold and use an asset (tangible or intangible), to exchange it, to keep income derived from it, and to do so exclusively, i.e. to keep others from likewise controlling the asset. Rights may be de facto only, or they may also have a legally protected status. This lecture concentrates on the legal aspect of property rights, and restrictions or limits on the rights to use, exchange, and keep income from assets. For example, one party may sell an asset to another, but the sales contract may forbid the buyer to use the asset in certain ways. Or government may pass and enforce a law forbidding certain uses of assets, or trades, or it may limit the amount of income the owner receives from an asset. In one sense, exchange itself involves attenuation of rights. Each party to a trade gives up some rights in exchange for others.

It should be noted at the outset that attenuation of rights differs from the case in which government restricts one party from violating the property rights of another. If, for example, it is agreed that an individual, Mr. A, has a right to his own life, then it is not an attenuation of Mr. B's rights to prevent him from attacking Mr. A in a life-threatening way, for Mr. B had no right to Mr. A's life in the first place. A right is always a limit on behavior, and helps to define the dimensions in which Mr. A may act, and Mr. B as well. Furthermore, when there is confusion as to who holds a particular right, it may be necessary for some mediation process to occur, e.g. a court of law may decide. The fact that rights are limited, and that these limits must be determined, does not necessarily constitute �attenuation� as the term is used here. Our analysis presumes that we begin with a particular distribution of property rights, and then discusses new limits placed on existing rights.

The distinction between this and the case in which property rights are poorly defined may be somewhat ambiguous, particularly since one individual may believe he holds a property right to some asset and that subsequent denial of this right amounts to attenuation, while others may deny his right and believe that rights have not been defined over the asset, or that they themselves hold the rights. We recognize this ambiguity and address it below. For now, we begin by assuming that an individual holds an undisputed property right to an asset. 1

Some attenuation of rights may be voluntary. For example, in the United States, landowners who sell their land sometimes do so under a contract that includes a covenant, a stipulation that limits the way subsequent buyers may use the land. At first glance, it would seem that restrictions would reduce the value of the land, since some options for use would no longer be available. Why would an individual with a property right in land voluntarily choose to place such restrictions on the property right, and why would a buyer be willing to accept these restrictions? Does the existence of such restrictions overturn our earlier arguments (e.g. in Lecture 4) that owners will generally assign rights so as to maximize the value of property?

Closer analysis suggests that these voluntary restrictions may actually increase the value of property. Consider the nature of these restrictions. Typically they forbid certain kinds of activity or development. For example, suppose that a piece of agricultural land is located near a growing city. A covenant on this land might specify that the land not be developed for housing, that it be kept as agricultural land. If a seller and buyer value open spaces highly, this may be a means of keeping the land in a state they prefer. Note that both parties pay the full cost of their actions in the case. Suppose that the land could be sold for two million U.S. dollars as a location for housing, while the present value of its earnings as farmland is only one million dollars. If the owner places a covenant on the land restricting its use to agriculture, and sells it for one million, it must be that the value he places on keeping the land in agriculture is more than one million dollars. Since he could have had the additional one million dollars by selling the land for housing, he bears the cost of his decision. Similarly, if any buyer is willing to purchase the land with a covenant, it must be that the attenuated rights are worth at least one million to him. Similarly, the potential buyers who would have developed the land for housing were unwilling to pay more than two million. Therefore, the value of the land was maximized by the placing of the covenant.

Suppose instead that the landowner were to sell the land without a covenant, to a buyer who simply verbally promised not to develop the land. The seller would have no way of enforcing the promise. The buyer might turn around and sell the property to a developer. Given the risk of this, the original owner might just as well sell the property to a developer himself, even though he values this less than selling the land with a covenant attached. Again, the placing of a covenant, an attenuation of a property right, is compatible with maximization of value.

Land covenants are often used in housing developments where the way that one tract of land is used influences the value of other tracts. For example, in a housing area with single family homes, private covenants may prohibit industrial activity, or may prohibit dividing a single home lot into multiple lots crowded with homes. This restriction maximizes value. Certain sorts of restricted activity on one lot, might lower the total value of all the lots taken together. Since transacting is costly, those homeowners who suffered losses might find it prohibitively costly to pay to prevent the �wrong� activity from occurring. All homeowners benefit from the restrictions placed on the use of their homes, and all agree to these restrictions when they purchase homes in the area. For example, in the western United States, there are housing developments designed for people who own and ride horses for pleasure. The rules of one of these developments � the Outlaw Subdivision near Bozeman Montana � provides that each housing tract be at least 4 hectares, that the owner not subdivide it into smaller tracts, and that the owner not build additional houses on the land. These restrictions are accepted by owners � people who value open spaces for riding � because they preserve and enhance the value of the land to them. Also, these contract terms often include provisions for making exceptions should some unforeseen circumstance arise � e.g. the homeowners might be able to vote to make exceptions in certain cases. Such a provision further increases the value of property rights by permitting the attenuation to be removed should economic conditions change.

In this example, rights appear do not appear to be partitioned, in the sense that no one retains the right to engage in certain kinds of development. Instead, these activities are prohibited for all � an attenuation of rights in any sense of the term.

Another approach to increasing the value of a right is to augment that right with certain services. An example of this is found in commercial sales that include guarantees. Yoram Barzel examines the case of a guarantee given by a manufacturer of a refrigerator to a consumer who purchases it (Barzel 2000). The consumer is unlikely to be able to evaluate the quality of the design, components, and workmanship of the interior mechanisms of a refrigerator. By guaranteeing these parts, the manufacturer increases their value. 2 Furthermore, the producer typically places restrictions on how the buyer may use the refrigerator without voiding the guarantee. The buyer may not abuse the refrigerator, nor use it for commercial purposes, etc. These attenuations of the buyer's ownership rights enhance the value of the refrigerator for both parties.

Of course, the buyer may still choose to abuse the refrigerator, or to use it commercially. However, in such case the manufacturer ends the guarantee at that point.

In these examples, attenuations are placed by mutual agreement of both parties to a trade. These voluntary restrictions appear to enhance the value of the resources and assets in question; otherwise the parties would not use them. The use of these restrictions also requires that the contracts embodying the restrictions be enforceable. That is, they require suitable institutions, such as contract law, and enforcement mechanisms, such as impartial courts (see Lecture 8). Given these prerequisites, attenuations can actually enhance the value of property rights.

However, an attenuation of property rights may be placed unilaterally as well, as when one party forces a restriction on another. For example, a government might pass a zoning law, a law that restricts how land may be used. Zoning laws typically place limits on using land for housing, for industry or commercial development, for agriculture, etc. Some areas may be designated as commercial, some as residential (housing) some as mixed use, etc. At first glance, these restrictions appear to be similar to voluntary covenants. However, there are important differences. Voluntary covenants and similar restrictions enhance the value of property, otherwise the owners would forgo the covenants. In the case of restrictions imposed by outside parties, value-enhancement is not assured. A given restriction might increase value, or it might instead reduce value.

Suppose a zoning restriction is imposed by government. It might be one which duplicates a covenant that owners would voluntarily choose. In such case, government might be the least cost provider of such a restriction, and the zoning restriction is value enhancing. On the other hand, government might impose a restriction that simply reduces the value of land. Suppose that a piece of agricultural land near an expanding city is highly valued by the owner and the potential buyer for developing housing, and no one places a higher value on the land for any other use . A restriction that prevents the land from being developed for housing reduces the value of the land.

Why would such a restriction be established? The most likely explanation is that some third party, perhaps a neighbor who enjoys the view over the land and wants no buildings there to block his view, opposes the development of housing on the land, and sees government intervention as his least cost method for preventing the development. If third parties like this are able to influence government decision making, they will be able to determine how the land is used. However, unlike the case of a private covenant, in this case the decision maker � the third party with influence over government policy � does not experience the loss of value that could have happened if the land were devoted to housing. The third party never would have received the benefits of the development, and hence ignores the benefits. The owner of the land loses the potential benefits, as do would-be buyers. Because the decision maker cannot collect some of the potential benefits, these benefits are not taken into account in the decision, and the result is that some valuable gains are lost.

This case is an example of rent-seeking. Rent-seeking, as the term is used here, refers to utilizing government policy to redistribute income and property rights in one's own favor. If government has the power to re-assign property rights, then individuals or groups who are able to influence government decisions can redistribute property rights to themselves, or attenuate the rights of others in ways that benefit themselves at others' expense.

One way to reduce such losses would be to limit the power of government to attenuate property rights. The ability of government to make such interventions might be restricted. This would eliminate the losses that would come from attenuating property rights. However, this would run the risk of forgoing government enforcement of beneficial attenuations. Even more problematic is the matter of how to restrict government. A government is a near-monopoly of force; compelling a government to obey rules is a difficult task. These issues are explored further in Lectures 6 and 8.

Attenuation of property rights, then, may enhance value in some cases, and reduce it in others. Private attenuations in a market setting (where exchange is relatively easy and contracts can be enforced) are likely to be value-enhancing. Government imposed attenuations may either be value-enhancing or value-reducing. There is no systematic force to direct these attenuations either direction.

Government regulation is a major source of attenuation of property rights. Government regulations cover an enormous range of behavior: use of property, quality standards for goods, restrictions on prices, and pollution standards, to name a few. Again, remember that we are considering government actions that attenuate rights, rather than actions that protect well-defined rights. If Mr. A has a particular property right of some sort, and government imposes a regulation that restricts this right, this is an attenuation. If government instead imposes a regulation restricting Mr. B from interfering with A's right, this is simply an instance of protecting property rights.

Regulation can strengthen property rights when parties cannot contract to minimize damages because transaction costs are high. For example, suppose that if a factory emits too much pollution, it will cause harm to people living nearby. Suppose further that individuals have the right not to be harmed by pollution from a factory. Several factories may be located in an area. If a person is harmed by pollution, it may be extremely costly for him to identify which factory is responsible, and to collect compensation. Since factory owners know it will be costly and difficult for a victim of pollution to hold them liable, they may go ahead and emit excessive pollution. A regulation that limits the amount of pollution the factories may produce might be the least cost way to correct the problem.

This could actually increase the total value produced in the economy. Suppose that the factory produces goods with a value (net of input costs) of 100,000 U.S. dollars per day. But the accompanying pollution damage is $50,000 per day. If the company were to take into account this damage, it would produce less: less output, and less pollution. Suppose that the reduction of pollution to acceptable levels requires that only $70,000 of output be produced, again, net of input costs, but at this point pollution damage is negligible. The regulation, properly designed , forces the factory to behave as if it took pollution damage into account. The total value in the economy can be maximized under such circumstances � in this case, the gain would be $20,000. (For a full discussion of these issues, see Coase, 1960.)

However, there's no systematic force to push regulation in this direction. Regulation might also be responsive to rent-seekers. Rent-seeking behavior might work in this way. Suppose only a small amount of damage is done by a factory, say $10 per day. However, suppose also that nearby homeowners are able to influence government regulation at very low cost to themselves. They might force the factory to meet stringent pollution standards, reducing the net value of its output from $100,000 to $50,000. Since homeowners had no stake in the factory's losses, and were able to influence government inexpensively, they take actions that result in a net loss.

In sum, there is no systematic force to pressure government to make decisions that maximize the value of resources. In some cases, government action may be a low-cost means of enhancing property values. In other cases, government action may reduce the value of property. The particular institutional details of the political system are crucial in determining this matter. It worth noting that value, in this case, refers to what members of society are actually willing to forgo to attain the use of a resource, that is, it is the maximum any members of society are willing to pay.

These examples have something in common: in each case, the conflict arises because property rights are not well defined nor fully enforceable. The factories operate as if they hold the right to use the atmosphere as a dumping ground for pollutants. The homeowners operate on the premise that they have the right to clean air. Furthermore, it is difficult to assign exclusive rights � the atmosphere is common property, accessible to all. What the government can do, either by regulation or through adjudication of disputes in a court of law, is to assign and enforce rights. Such activity in effect establishes property rights that were in dispute. Since this activity tends to be unilateral, rather than mutually voluntary by all parties, there may be no systematic tendency for this to be done in a manner that maximizes value. (Coase argues that in the case of England, courts using English common law had a systematic tendency to assign disputed rights so as to maximize total value; the literature on law and economics often uses maximization of value as a normative criterion for evaluating institutional arrangements underpinning private property.) Lecture 9 examines in depth the problem of open access common property, such as the atmosphere.

Taxation to support government.

Taxation is a form of attenuation of property rights � attenuation of individuals' wealth and income streams. If individuals hold property rights in assets, including to income derived from the assets, then taxation reduces this stream and attenuates the property right. However, as with regulation, the attenuation may be value creating or value reducing.

Economists frequently argue that the proper role of the state is to provide public goods. The economic theory of public goods suggests that such goods are non-exclusive (i.e. one cannot exclude others from consuming it) and non-rival in consumption (i.e. one person's consumption does not reduce the amount of the good available to others). Examples are national defense and impartial enforcement of law. These differ from private goods, which tend to be exclusive and rival in consumption. A public good is likely to be underprovided, relative to private goods, because producers cannot capture payment from those who benefit � the �free-rider� problem. Underprovision is not in the interest of consumers, so if a mechanism can be developed to enable each consumer to commit to paying his share, the good can be provided in the �optimal� quantity. Government is one such mechanism. Since the state has a near monopoly over force, it can compel each person to pay his share towards provision of a public good, and then use these taxes to provide public goods.

If the goods and services provided by the state are truly public goods and the state provides them in optimal amounts, then in principle everyone is in agreement and is willing to pay (submit to taxation). By obtaining the public good, each person gains net benefits, and therefore is willing to submit to the commitment device (taxation). In this case, taxation is just a commitment device to avoid free-rider problem and permit acquisition of public goods.

However, by virtue of having a near monopoly on force, government is able to diverge from this role and levy taxes for other purposes, e.g. purposes taxpayers oppose. And because taxation is a mandatory payment individuals must make and is not usually linked to their consumption of government goods and services, payments to government do not depend on successful provision of goods and services. Taxation separates provision of service (by a government agency) from its payment for providing service. Hence, government bodies tend to operate with what is called a soft budget constraint. They may provide goods and services unrelated to the wishes and needs of many or all of the taxpayers, and continue to do so without fear of bankruptcy � tax payments provide their budgets, and citizens have little choice but to pay, or take risky and costly measures to avoid taxes. 3

Hence, the case of taxation is ambiguous. To the extent that government provides desired public goods in a cost effective manner, taxation to support government � an attenuation of property rights � creates additional value in the economy. But if government uses taxes for other purposes, the activity may be value-reducing. Furthermore, costs of avoiding taxes are another source of loss, since resources used in protecting wealth from taxes could have been used to create additional wealth. And because it is difficult to constrain government to merely providing correct amounts of public goods, it can be expected that would-be rent-seekers will expend resources to try to influence government policy.

Taxation to support redistribution.

Taxation is also used by government as a method of redistributing wealth and property rights. Again, this attenuates the property rights of those taxed. It is difficult to argue that those taxed are made better off by the redistribution. Rather, transfers tend to benefit recipients while hurting those taxed. Of course, it could be argued that it is the long run interests of those taxed to have these benefits bestowed on the recipients. While this might be theoretically possible, it is difficult to imagine real cases in which those taxed are made better off by transfers. Typically, recipients gain and taxpayers lose.

When government is able to engage in redistributive taxation, rent-seeking is encouraged. Any group able to influence government policy will be able to (indirectly) use the redistributive power of the state o benefit itself. The fewer the limits on the state's power to redistribute wealth, the higher will be the potential returns to rent-seeking behavior, and the more rent-seeking activity will be observed. Also, fewer limits on the power of the state to engage in redistribution imply weaker private property rights. As we have seen, weaker, more poorly defined rights are less effective in promoting wealth creation, since more resources will be spent privately on protecting existing wealth and less on creating new wealth. In fact, an increase in the power of government to redistribute rights and wealth is equivalent to reducing the exclusivity of rights. In the example of the atmosphere and air pollution discussed above, government was able to increase total value in the economy by assigning and enforcing property rights where rights had been poorly defined. In the case of redistribution, the government does the reverse � its power to redistribute wealth takes well-defined rights and makes them poorly defined and uncertain.

There are, however, ethical arguments for redistribution. In countries undergoing reform, previous regimes may have assigned property on a basis that is considered unjust by the public. For example, in the former centrally-planned countries, communist party officials used their connections to capture personal wealth and property. Similarly, in many developing countries, leaders of authoritarian regimes distributed land and wealth among their supporters, helping to impoverish the population in general. In such countries wealth may be concentrated in the hands of a small, politically influential elite.

Suppose an oppressive government has placed much of a country's wealth in the hands of its supporters, a relatively small group. Then one day a reform-minded government replaces the oppressive regime, and wishes to rectify some of the damages done and promote economic development. It is likely to want to protect property rights in general to promote economic growth and political harmony. But it is unlikely to wish to leave substantial wealth in the hands of supporters of the old regime. An argument for a one-time redistribution of wealth might be made in such cases. Such a redistribution might well stimulate the creation of wealth in the economy, in addition to rendering justice.

The ethical case for such a redistribution is easy to see. After all, if property has been stolen, it is not a weakening of property rights to return it to the owner. Depending on the nature of the claim against those who obtained property under an old regime, the case might be similar. Such a redistribution might even signal a future willingness of the new regime to defend �3D� rights for the entire population � hence there would be general expectations that property rights would be seen as more secure, encouraging investment and entrepreneurship.

However, redistributing property could potentially increase overall productivity. An elite minority might well forgo more productive uses of their property, if such uses implied the necessity of contracts that would jeopardize their grasp on power. For example, it is clear that the North Korean economy could be far more productive than it is now if it were to be reorganized. Despite this, the elite � Kim Jong Il and his ruling clique � do not restructure even though this would create a net gain from which they could, in principle, benefit. They do not restructure because to do so would jeopardize their grasp on power. In other words, the contracts that would permit restructuring and maintain the elite's position are unenforceable. There may be analogous cases in other less developed countries.

Of course, the redistribution might instead signal a willingness to engage in future redistribution on an ad hoc basis, suggesting that property rights are insecure. In such a case incentives to invest in productive activities will be reduced. The particular historical and institutional details are crucial in distinguishing between these two cases.

Have property rights been attenuated in such a redistribution? Clearly, the de facto rights (control) of the former elite have been attenuated. Their de jure (legal) rights are simply denied to have been valid. The merits of the de jure case can be decided only by political philosophy and ethics, not economic theory. The likely effects of the redistribution can be predicted by economics.

If a goal of a redistribution is to foster economic prosperity, then the redistribution should be a unique, �once shot� event. Continual redistribution creates incentives for property owners to take costly measures to protect their wealth, instead of engaging in productive activity that creates additional wealth. For example, many less developed countries and transition countries have suffered from capital flight, as owners of wealth seek safe havens where the risks of confiscation are less. This decreases potential investment in the country, in turn preventing increases in productivity and income that might have been had under a framework of more secure property rights. Therefore, tax policy is likely to be a poor tool for such a wealth-enhancing redistribution. This is because the redistribution would need to be a unique event, invoked on some sort of principle (e.g. improper acquisition of wealth). But taxation is an ongoing policy, and targets the general populace.

Another argument for redistribution, also based on an ethical principle, is taxation for continual redistribution. An extreme version would be taxation to promote egalitarianism. If egalitarianism � understood here to mean equality in income or wealth for all members of society � is considered to be a desirable objective, then taxation for redistribution is almost certainly implied. In general, individuals differ in abilities, interests, etc. and will therefore differ in abilities to earn income and amass wealth. If these differences are deemed undesirable, then taxation for redistribution is among the most likely means of reducing disparity. Such a tax policy would differ from the one-shot redistribution discussed above. It would be necessary to maintain it, since individuals would continue to differ in abilities to earn wealth. However, a tax policy to redistribute wealth in this manner clearly weakens private property rights and destroys incentives to create wealth. Those who pay the tax find earning income less rewarding, while those receiving the benefits base on low incomes also find earning more less rewarding; rather than paying more tax, they receive reduced transfers when they earn more. Because of these incentives, an economy with substantial and continual redistribution will have poorer performance than it could have with better incentives; a truly egalitarian redistribution will be particularly subject to stagnation and decline.

In sum, the economic effects of redistribution of property rights depend upon particular circumstances. Redistribution could promote security of property rights and creation of wealth, but could easily have the opposite effects � particularly when it appears as a continual policy, rather than a one-shot program to right some perceived wrong. Taxation for redistribution is likely to have these latter effects. Also, if it is agreed that some redistributive programs might be justified and others not, the issue of how to constrain government to engage only in proper redistribution will arise. Permitting one while preventing the other may be problematic.

One interesting application of this analysis for formerly centrally planned countries concerns the question of some of the early privatizations. Privatizations of state property often favored insiders and political elites, and the desirability of such transfers is sometimes questioned, on the bases of justice and economic effects. It is sometimes proposed that these privatizations should be undone, that is, the property rights nullified and a new, more transparent privatization undertaken. The possible benefits of such a re-privatization must weighed against the dangers of establishing a precedent for continual redistribution and the resulting insecurity of property rights. From a policy standpoint, a sensible solution might be to nullify privatizations only in cases where specific and demonstrable wrong-doing on the part of beneficiaries can be established. This requires, of course, some publicly accepted definition of constitutes wrongful behavior.

Limits on contract.

Governments place limits on the kinds of contracts that can be written and enforced, that is, on the terms of contracts. These can be seen as attenuations of the rights of holders of property rights to transfer these rights. Common limits include restrictions on labor contracts, antitrust restrictions on corporate mergers, and limitations on trade in certain kinds of goods and services, such as drugs or prostitution. In each of these cases, the state may well recognize the general property rights of parties, including their rights to mutually agreeable transfers. But in certain dimensions restrictions are placed on these even while recognizing the rights in general.

There are two commonly expressed rationales for these kinds of limits. One is that certain kinds of contracts must be ruled out, because the contractual terms suggest the parties were not capable of reaching a mutually agreeable and acceptable outcome. For example, in developed economies one cannot agree to become another's slave � the terms of labor contracts are restricted. Furthermore, these restrictions include limits on length of the workday, working conditions, etc. The rationale is that workers either cannot choose wisely, or that their bargaining position is sufficiently weak that they would be unable to obtain more desirable terms.

Such arguments for restrictions tend to reflect two things. First, the arguments presume a normative standard � e.g. slavery is not acceptable, even if entered into voluntarily, or it is not acceptable that workers should be required to work more than some number of hours per day, etc. In the U.S., individuals are assumed not to be fully capable of evaluating the characteristics of pharmaceutical drugs, and therefore many restrictions are placed on what can be sold. Similarly, it is often argued that use of recreational drugs, prostitution, and similar activities are harmful to those who engage in them, and therefore should be banned. These all are normative arguments that presume the inability of contracting parties to choose wisely. Second, the arguments often presume weaknesses in bargaining positions such that individuals are unable to reach �acceptable� contract terms. This rationale includes both positive and normative elements, since it includes a definition of what is acceptable, but also depends upon the existence of some positive constraints � e.g. workers are unable to negotiate for better terms against employers because workers are more constrained than firms. In this view, firms (employers) are able to dictate terms of a contract because they have stronger bargaining positions � they have many workers to choose from while workers have few job offers to choose from, firms have reserves that permit them to take tough negotiating stances while workers do not, firms are united while workers are disorganized (unless unionized). Therefore, some limitations on contract are called for to prevent �unacceptable� contracts arising from the disparities in bargaining power.

The second common rationale for limiting the terms of contract concerns third party effects, so-called externalities. Even when all parties to a contract clearly benefit, some third parties may be injured; hence certain limitations should be placed on contracts so as to limit these harms to third parties. This rationale is often used in arguing for prohibitions on prostitution and recreational drugs. Another example is antitrust legislation, restricting the transfer rights of owners of firms. The argument is that in some cases mergers will have the effect of creating firms with market power, e.g. monopolies. Simple neoclassical analysis suggests that this can increase firm profits while reducing total value created in the economy � thus harming consumers. Since increase in profit is less than the loss in consumer surplus (the standard measure of consumer gains from trade), such a merger is deemed undesirable, and is often prohibited, at least in principle.

Of course, one difficulty is measuring and demonstrating the alleged effects, and ensuring that a limit on contracts is indeed preventing such effects. Individuals supporting restrictions limits on contracts may have reasons other than the expressed rationales; the expressed rationales for limits are in fact often camouflage for other motivations. For example, a proposed merger might result in a firm better able to compete on the market. Competitors might seek antitrust action to block the proposed merger by claiming it will result in monopoly, when their real reason for blocking the merger is to reduce competition and thus protect their market share. Such a limit on contract pretends to restrict harmful effects on third parties, but instead promotes such effects.

In sum, limits may be placed on the right to contract in order to limit terms that are generally held to be unacceptable by some standard, or to avert harmful effects to third parties and possible net losses. However, in all cases, the ability of the state to place such limits raises the possibility of such power being diverted to create benefits for a small group at the expense of the others. This is another example of rent-seeking.

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REFERENCES

Barzel, Y. 2000. Economic Analysis of Property Rights . 2 nd ed. Cambridge University Press.

Coase, R. 1960. �The Problem of Social Cost.� Journal of Law and Economics 3(1): pp. 1-44.

Norton, S. 1998. �Property Rights, the Environment, and Economic Well-Being.� In Hill and Meiners, eds. Who Owns the Environment? New York: Rowman and Littlefield Publishers 1998.

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1 It is sometimes alleged that positive economics can distinguish between so-called �protective� or negative rights, and �intrusive� or positive rights (e.g. Norton, 1998). However, this is so only given a particular distribution of property rights. Positive analysis cannot identify whether a particular action constitutes protection of rights or redistribution of rights, unless one first defines the proper distribution of rights, a normative standard. Does forcibly transferring an asset from Mr. B to Mr. A constitute theft, or the return to Mr. A of what is properly his? Is it protection or redistribution? A normative standard is required to answer this question.

2 Barzel actually refers to this as the manufacturer retaining a property right in the refrigerators� in this case, a responsibility to replace or repair should they be defective. This enhances the value of the refrigerator, since the producer is able to evaluate (and influence) the quality of the interior mechanisms. By retaining a dimension of ownership over the refrigerator, the producer shares rights over it with the buyer.

3 State enterprises under central planning provide the classic example of a soft budget constraint. Firms' budgets did not depend on the value of the output they produced, one important reason why socialist production was often of inferior quality, and sometimes constituted negative value added.