The property rights model: Recapitulation
People have discretion over how to delineate rights, and as part of their maximization effort they do so to whatever degree they desire. Rights are never perfectly delineated, however, because the fact that commodities are not uniform and are expensive to measure makes perfect delineation prohibitively costly. Nevertheless, since people do what they deem “best,” rights may be said to be always optimally delineated.
Those properties that people choose not to delineate lie in the public domain. Such properties include much of the world's oceans; they also include the cool air in air-conditioned shopping malls, which is not charged for on the margin. Properties in the public domain can be augmented or diminished. As the values of commodities and of commodity attributes change, and as the costs of delineation and of protection change, people's decisions regarding what to leave in, what to relinquish, and what to reclaim from the public domain change correspondingly.
The public domain is ubiquitous; innumerable commodity attributes are placed in it. Any service not fully charged for on the margin is at least partly relinquished to the public domain. Owners could charge for such services, but the extra returns often do not justify the extra costs. For instance, concert-hall owners relinquish to the public domain the differential in valuation among equally priced seats. When the value of concert-hall seats falls – which might happen when the hall is used by a local choir rather than a famous
opera star – seats are expected to be priced in lesser detail. The differences in value
among seats that were formerly differentially priced are relinquished to the public domain. Patrons are expected to claim that differential through the expenditure of resources. Resource owners attempt to maximize the net values of their resources: They attempt to organize their actions so that, ceteris paribus, they minimize the losses from placing attributes in the public domain.
In order to gain from exchange, people must spend resources on transferring rights to commodities. Transactors structure their contracts so as to minimize the costs of exchange of given transactions. In forming the contracts, transactors have a choice of units by which to regulate their transactions; for instance, labor can be exchanged by the hour or by the piece. The use of each of these units relinquishes different subsets of attributes to the public domain: the per-hour effort when labor is sold by the hour; the care or quality of the output when labor is sold by the piece.
In addition to having a choice of units, contractors may also impose restrictions on the way they conduct their exchanges in order to reduce the amount spent capture. Refrigerator producers, for example, often make the sale of their merchandise subject to a warranty, while at the same time prohibiting buyers from using their refrigerators commercially. The warranty service is a free attribute to buyers in that they are not as heavily penalized for carelessness or for extra-heavy use, as they would be if they had to pay for repairs themselves. The restriction serves to reduce such usage. The more valued
transactions are, the more attributes are expected to be priced, or the more comprehensive the restrictions are expected to be.
Since exchanged commodities are not uniform and are not fully measured, the value of the exchange is variable. A contract allocates the variability in a transaction among the transactors. As transactors alter the units by which they effect exchange, and as they alter the associated restrictions, they also divide the variability in outcome among themselves differently. The allocation of variability which maximizes the contractor’s wealth, is the one wherein the ability of a contractor to affect the value of the mean outcome of the transaction is positively related to the share of variability he or she will assume. It is expected, for instance, that refrigerator manufacturers will assume variability in income by guaranteeing more comprehensively those aspects of their refrigerators’ performance
that are most affected by their production procedures yet least likely to be affected by consumers’ actions. As was noted earlier, whereas a refrigerator's paint is guaranteed for only a short period, the warranty on its motor remains in force for several years. All sales, with the exception of some governed by caveat emptor, require organization. In sales subject to caveat emptor, buyers need to assure themselves that they will not walk away with worthless merchandise. If buyers check directly, the degree of organization may be trivial. Not trivial, however, is the resource cost of such exchanges. Non–caveat
emptor sales, that is, sales in which the transactors have imposed constraints on each other, require organization in order to police and to monitor the constraints. The nature of, and the costs associated with such organizations vary with the pricing method used. A change in conditions, such as a change in the valuation of the transacted commodity, is expected to change the method by which the commodity is sold, as well as the organizational structure governing its exchange.
Who will post the price at which to commit to trade, the seller or the buyer? The theory presented here yields the implication that whichever party can better predict prices will be the one to post them. Whoever posts a price subjects himself or herself to exploitation; his or her exchange partners may engage in excessive price prediction, discover prediction errors, and take advantage of the willingness to deal at a fixed price. It is further implied that the person who can more readily predict the price will be the one who will assume the consequences of posting it. Price prediction is subject to economies of scale; the more units traded at that price, the lower the unit cost of the prediction. Thus, as the size of the buyer vis-à-vis the seller increases, the more likely are buyers, whose unit cost of prediction has declined, to post prices at which they agree to purchase what sellers wish to sell.
Because all but the lowest-value transactions are subject to constraint and require organization, only a small fraction of transactions are fully “in the market,” as this term is usually understood. The frequently asked question as to which transactions will take place in the market and which will remain within the firm is not likely to receive a useful answer, however. Firm transactions have many attributes, and some of them are more in the firm than others. A more fruitful question concerns the determination of the forms of
organizations that will govern different kinds of transactions and of the forces that will bring about change to these organizations.
The complexity of commodities and activities causes ownership patterns to be complex as well. The most efficient owner of a particular commodity attribute is not necessarily the most efficient owner of the commodity's other attributes. It may be advantageous to split the ownership of a commodity among several individuals. Because the commodity is itself not physically split, each owner, if not properly constrained, may find it easy to consume some of the others’ unpriced attributes. In the previously mentioned restriction on the commercial use of refrigerators, the owner of the attribute “warranty service”
restricts the behavior of the owners of some of the refrigerator's other attributes. Organizations, including business firms, typically engage in a multitude of activities, including policing and monitoring constraints. In the case of the business firm, many factors affect the variability in its income. The price of each commodity it buys or sells can fluctuate, each specimen of the commodities it exchanges may differ from others, and its income may depend on whether or not such phenomena as fires, earthquakes, and foreign confiscations occur. Each of these instances of income variability may be borne by a different party. A firm may purchase a raw material on the spot market, or it may operate under a long-term, fixed-price contract for it. Assuming no breach of contract, in the former case the buying firm bears the effect of fluctuations in the price of the commodity; in the latter case its contract insures it against fluctuations. These considerations apply to all the firm's sources of variability. In each of these instances it is expected that the party that is better able to affect the mean outcome will tend to assume the associated variability. For example, it is expected that a raw-material supplier that has some power to set its price is more likely to sign fixed-price, long-term contracts than one not possessing such power.
Similar considerations apply to labor services. Workers, who can affect outcome-value more easily than the purchaser of the labor services can, are likely to operate as independent contractors selling output rather than labor. At the other extreme, purchasers of labor services will assume variability in outcome by paying a fixed wage on a long-1 term basis. It is to be expected that as the market wage of workers rises, they will gravitate toward self-employment.When two parties agree to a formula for dividing future income variability, one may emerge as the winner and the other as the loser as the outcome of the transaction unfolds. Because the loser could gain by reneging on the contract, each party demands assurances from the other that the contract will not be breached. A necessary though not sufficient condition for such assurances is that a party be able to meet his or her obligations. Fixed-wage suppliers of labor can readily guarantee performance even when the market wage exceeds the contract wage, because they own their own labor services. The employer of such workers must be able to ensure wage payment when the market wage falls below the contract wage, and equity capital specializes in providing such assurance. More generally,
1 Barzel 1987.
it seems that equity capital is assembled (and augmented) in order to guarantee all the
contracts signed by the firm. These contracts may, in turn, be viewed as constituting the CONCLUSION firm; in this sense shareholders are the owners of the firm, and the firm is a “nexus of
contracts.” I have attempted to demonstrate how the property rights transaction cost model can
generate a better understanding of the allocation of resources and of the interaction of this allocation with economic organization. The literature that assumes that the costs of
transacting are zero and that all property rights are perfectly well delineated is incapable
of dealing with a vast array of actual observed practices. Particularly glaring is the
inability of such an approach to explain why exchange parties would ever impose
restrictions on each other. The property rights approach is capable of addressing such
Many approaches to the analysis of economic behavior do not explicitly assume that
transaction costs are zero, but they also do not inquire as to what the precise rights of the parties are. It is my impression that economists who neglect property rights
considerations are prone to making implicit assumptions that are often not well taken,
while producing results that are hard to accept. It is quite common to find cases where
within single models some transaction costs are implicitly assumed to be zero (e.g., it is
routinely assumed that monopolists know precisely what their demand is) while others
are assumed to be prohibitively expensive (e.g., it is routinely assumed that price
discrimination by monopolists is prohibitively costly).
2 The approach that insists on
asking who owns every particular attribute of a commodity and what “owners” can
actually do with “their” commodities seems to come closer to the root of transaction costs
and is, therefore, less likely to fall prey to untenable assumptions.
Finally, consider the application of the property rights approach to the distribution of
gains from trade. Many goods are valued less by their current owners than they are by
other individuals. Who owns these potential gains from trade? In the competitive, zero
transaction cost model, the distribution of the gains is costlessly determined. The costless
information (or the uniformity of commodities) necessary for such competition is,
however, seldom encountered in reality. Opportunities for people to gain at the expense
of others seem ubiquitous. Whereas individuals are always ready to expend resources to
increase their share of the pie, they will also seek out methods and organizations by
which to better delineate rights to it, thereby dividing the pie without shrinking it too
A considerable portion of this book has been devoted to analyzing such behavior. It is
fitting to conclude by visiting one unlikely place where the time and effort of haggling
2 Another example occurs in asymmetry-of-information models, where one set of
individuals is, as a rule, implicitly assumed to be costlessly informed, while for others the
information cost is assumed to be prohibitive.
over the distribution of the gains from trade are effectively avoided: an Egyptian bazaar.
To quote Werner (1987), in Cairo's “principal livestock market, camels take center
stage. . . . [T]he camel market's own King Solomon [is] Muhammad Abd al-Aziz. . . .
Sales are conducted one-on-one – one buyer, one seller and one camel at a time. . . . With
an acutely discriminating sense of camel flesh [Muhammad] sets a fair price. . . . His
authority is usually sufficient to settle any difference.” Transaction costs are near zero in
this particular market. Nothing, however, comes free. Here the cost in question is “a
small margin for [Muhammad's] commission” (p. 132).