Three Types of Public Ownership

Econ 522 – Lecture 8 (February 12 2009)

Tuesday, we discussed

Three types of public ownership
Ways in which property rights are established, verified, and lost
Limitations on property rights
laws against perpetuities (the inability to permanently restrict your heirs)
rights to use others’ property in an emergency
inalienability (the inability to sell something)

Today, we’ll wrap up property law with

A couple more ways in which property rights are limited
Unbundling
Eminent domain/takings
Regulation
And a return to remedies when property rights are violated

One more example of limitations to property rights: Unbundling

Earlier in the course, we defined property as “a bundle of rights,” that is, a collection of rights that you have over the use of your property

In some instances, an owner may want to unbundle these rights
that is, separate them, so that he could sell some of them and hold onto others
In most instances, this is not allowed – an owner may be permitted to sell the bundle as a whole, but not in pieces.

A great example of unbundling comes from Pennsylvania

Pennsylvania was largely built on coal
lots of land has coal under it
lots of money was made by mining this coal

In Pennsylvania, as of the late 1800s and early 1900s, land ownership consisted of three separable pieces, referred to as “estates”
the surface estate – the rights to use the surface of the land (build a house on it, grow corn on it, whatever)
the mineral estate – the rights to whatever coal lay underneath the surface
and most interestingly, the support estate – the rights to whichever parts of the underground structure are holding up the surface.

If I owned the surface and support estates, I could build a house on the land and live there
If you owned the mineral estate, you could mine coal from my land, but if my house began to sink, it was your fault and you owed me damages
That is, by owning the support estate, I had the right to my house not falling in.

On the other hand, if you owned both the mineral and support rights, you could mine the coal however you wanted
If I owned the surface, I could still build a house
But if the surface fell in as a result of your mining operation, I had no recourse, since I owned the surface but not the right to have it held up.

In this case, the “support estate” wasn’t tangible property
But it made it completely clear who had the rights to do what with the property, and the three property estates could be bought and sold separately.
(I don’t think the support estate had any value on its own.)
There’s an interesting case from the 1920s, Pennsylvania Coal vs Mahon, which is discussed on the textbook website – we’ll come back to that case later today, because it’s interesting for other reasons.

Land in Pennsylvania is one example where an unbundling of rights was allowed

But there are also many instances when unbundling is not permitted
On Tuesday, we saw one situation where it isn’t permitted
I can’t place permanent restrictions on how my heirs will use my property
so I can’t separate the right to live on my property from the right to turn it into a golf course
that is, I can’t pass on to future generations the right to own and live on the property, but keep for myself the right to determine how it’s used
Similarly, the owner of a vacant lot might be able to sell it whole, but zoning restrictions may prevent him from dividing it up into smaller pieces and selling them separately

In general, neither the common law nor the civil law allow free unbundling and repackaging of property rights

The civil law tradition is the more restrictive of the two
In the civil law, the rights which come with property ownership are attached to the property itself, not to the owner
so they typically cannot be separated at all.

To illustrate unbundling, the book gives an example of two brothers, one of whom inherits a watch that’s a family heirloom
The other brother wants to be able to wear the watch at a family Christmas party every year
If unbundling of property rights were allowed, the brother could buy the “Christmas rights” to the watch, with the heir retaining all the other rights
Then if the heir sold the watch, he could only sell the non-Christmas rights to it, since he did not possess the Christmas rights, and the brother would have a legitimate claim against the new owner to wear the watch on Christmas.

The example helps explain why property rights generally can’t be unbundled
Unbundling creates uncertainty that may hamper future trade
In this case, it might be very hard for the owner of the 364-day rights to the watch to sell it, since buyers might only be interested in buying a “whole” watch.

Of course, if rights could be unbundled, they could presumably be re-bundled
But if they were unbundled and individual rights sold to lots of different owners, the transaction costs of rebundling might be overly high.

Efficiency would generally suggest that unbundling should be allowed when it increases the value of the property
But if rebundling the rights in the future would be costly, this may argue against unbundling
One could also argue that unbundling leads to greater uncertainty
In a world without unbundled rights, when I buy an apple, I know exactly what I’m getting
In a world with total unbundling, before buying an apple, I would need to verify that the seller owns the specific rights that I want to acquire – say, the eating rights – and not just the right to carry the apple
Thus, excessive unbundling might increase transaction costs in general.
Which would argue against it

Next, on to remedies for Violations of Property Rights

(This is partly a review of the Calabresi and Melamed material we saw earlier)

The book made the case earlier that the common law roughly approximates a legal system of “maximum liberty”

I can do whatever I want with my property as long as that doesn’t interfere with anyone else’s property
When the use of my property does interfere with someone else’s use of theirs, we have an externality
In property law, harmful externalities are called nuisances.

When an externality is imposed on a small number of others, we say it’s a private externality, or in the language of public and private goods, a private bad

In these cases, transaction costs should generally be reasonably low, and the problem can be solved through negotiation.
(This might be the case with neighbors fighting over a tree that crosses the property line.)
In these cases, relief by injunction is generally attractive
the court does not need to go through the exercise of calculating damages
and the clear enumeration of property rights will hopefully encourage the neighbors to reach an efficient outcome by bargaining.
(We saw this with the example of the brewery whose smoke affected only one consumer – he and the brewery could agree to a Pareto-improving transaction to reduce pollution)

On the other hand, when an externality is imposed on a large number of people – as with a factory polluting air in an area of dense population – the transaction costs of private negotiation are often prohibitively high

This is a public externality, or public bad
In these cases, from an economic point of view, damages are ideal
Damages cause the factory to internalize the externality – that is, the cost to the neighbors becomes a private cost to the factory
But the factory can still choose to accept this cost and continue polluting when this is efficient
(With high transaction costs, an injunction would likely force the factory to stop polluting, which may not be efficient.)

Compensatory damages is the term for damages intended to “make the victim whole,” that is, to return the victim to being as well off as he or she was before the harm occurred

(We’ll come back to other types of damages later on, in contract and tort law)

Compensatory damages can be either temporary or permanent
Temporary damages compensate for harms that have already occurred.
Permanent damages compensate in addition for the present discounted value of harm that is expected to be done in the future
By paying temporary damages, a factory compensates the neighbors for whatever pollution has already occurred
By paying permanent damages, the factory is effectively pre-paying the neighbors for the right to pollute in the future

There are pros and cons to both types of damages

Temporary damages require the victim to keep returning to court if the harm continues, and require the court to keep calculating the amount of damages each time, so they impose a high transaction cost
However, under temporary damages, reductions in the harm itself lead to reductions in the damages owed, so the factory has an incentive to take steps to reduce pollution, or to pay the neighbors to take steps that reduce the harm on their end if this is more efficient.
On the other hand, permanent damages are a one-time, permanent fix, and therefore less costly to implement
But once permanent damages have been paid, the factory is not penalized for any additional harm they do (they’ve already paid for it); so there is no incentive to reduce the harm as technology makes this easier
In addition, since permanent damages are based on the expected discounted value of future harm, it depends both on future technology and future prices, which cannot be predicted with accuracy
So permanent damages suffer from higher error costs, that is, inefficiencies that are introduced when the amount of the compensation is incorrect.

So Cooter and Ulen offer the following proscription for appropriate nuisance remedies:

if a nuisance affects a small number of people (private nuisance), award an injunction, and count on the parties involved to negotiate an efficient solution
if a nuisance affects a large number of people (public nuisance), damages are more efficient
if damages are easy to measure and innovation occurs rapidly, temporary damages are more efficient
if damages are difficult (or costly) to measure and innovation occurs slowly, permanent damages are more efficient

However, this is not what is typically done in practice

With public nuisances, the remedy tends to be temporary damages (for harm already incurred) and an injunction against future harm
However, there’s an interesting case that shows the court becoming more receptive to damage remedies for public nuisances, in spite of all the precedent in favor on injunctions.

The case is Boomer v Atlantic Cement Co, decided in 1970 by the NY Court of Appeals

Defendant owns a large cement plant near Albany, which, along with cement, produces dirt, smoke and vibration
The neighbors sued, the plant was found to be a nuisance, and they were awarded temporary damages, but denied an injunction against future harms
Plaintiffs appealed, requesting an injunction.

The appeals court ruling was very interesting
They agreed that yes, this was a valid nuisance
And yes, nuisances are generally remedied with injunctions
But in this case, the harm of forcing the plant to close so greatly outweighed the level of the damage being done that they refused to issue an injunction, and instead ordered permanent damages to be paid
They pointed out that the two sides could settle the issue instead through voluntary negotiations, but that “the imminent threat of closing the plant would build up the pressure on defendant…”
They also pointed out that techniques to reduce dirt and vibration from the cement production process would be developed by the industry as a whole, not just by this one plant, and that these were therefore outside the defendant’s control and unlikely to occur within a short time
The court had estimated the total of permanent damages to all plaintiffs to be $185,000
And the company had invested $45,000,000 in the plant and it employed 300 people
So the court refused to issue the injunction.
(Technically, they issued an injunction that would automatically be vacated once permanent damages to the plaintiffs were paid.)
They also noted that the damages were paid as “a servitude to the land,” that is, the fact that damages had been paid attached itself to the land, not the individual plaintiffs
So if these plaintiffs, having already received permanent damages, sold their property, the new owners could not sue for damages
Instead, the ongoing nuisance caused by the cement company would simply be a feature of the land, and would presumably be figured into the price that they could sell it for.

Permanent damages typically compensate for “all reasonably anticipated future harms.”

Presumably, if Atlantic Cement in the future were to expand greatly, or adopt a much noisier or dustier process of production, these new harms would still be liable for damages; but the established level of harm had already been compensated.

Next,Takings.

Earlier, we discussed the fact that when public goods are privately provided, they tend to be undersupplied
It follows, then, that one important role of government is to provide public goods
Defense; roads and other infrastructure; parks; to a certain degree, art and science; lots of public goods are, and should be, provided by the government.

In order to provide these things, the government sometimes has to use land which would otherwise be private property
In some cases, the government can simply negotiate with the owner to buy this land
But as we’ve discussed, it’s very hard to negotiate with a large number of people at once
if the government needs to buy a large area of adjoining land, which is currently owned by many different people, it may be impossible to negotiate the sale voluntarily.
(As we’ve discussed, individual landowners may hold out, hoping to get inflated prices once most of the other land has already been bought up.)

In most countries, the government has some right to seize private property even when the owner doesn’t wish to sell

This is referred to as the right of eminent domain

Not too surprisingly, this type of seizure is also called a taking

In the U.S., takings are limited by the Fifth Amendment to the Constitution, which attaches two conditions:
private property may only be taken for public use
and only be taken with just compensation

“Just compensation” has consistently been interpreted to mean fair market value

that is, what the owner would likely be able to sell the property for
(This may be less than his subjective value for it, or the price he would voluntarily accept – too bad!)

The need for a right to government takings, and the limiting of compensation to fair market value, is fairly clear

Calculating someone’s subjective value directly would be impossible
And allowing the owner to name his price would be the same as removing the power of eminent domain and simply requiring the government to buy property openly.
In situations where many possible sites are available, this might be fine.
But in a situation with only a single possible location for a valuable public good, the owner of the property could demand an unreasonable price (not because he valued the property that highly, but because he thought the government would pay it).
Similarly, if lots of adjacent bits of land were required (say, to build an airport), some owners might hold out, hoping to get high prices once most of the property had been bought up.
The government would then have to either fund the purchase through higher taxes (basically, redistributing wealth from all of society to one person who is already probably relatively well off since he owns property), or fail to provide a valuable public good
So public goods would continue to be underprovided, which is the situation we were trying to avoid.
So the rationale for allowing takings, and limiting compensation to fair market value, is pretty clear

The two limitations on government takings – that the government can only seize private property for public use, and only with compensation – seem to agree with some notion of fairness.
But they also serve another purpose – to discourage the government from abusing this power

If the government could seize private property without compensation, this would give it another way (besides taxes) to finance itself
Uncompensated takings would function like taxes targeted at specific individuals
But we come back to the general principle that the more narrow a tax is, the more distortion it causes, because people will go to greater lengths to avoid paying the tax, which makes it inefficient
The more broad a tax is, the less distortion it causes, and therefore the less inefficiency.
So the government should be discouraged from using takings as a source of financing, which is ruled out by requiring compensation.
(If compensation were not required, this would lead people to take costly actions to make their property less attractive to the government
That is, if the government were looking for a suitable place to build a park, people who lived in attractive locations might start cutting down their own trees, or spilling chemicals on their lawn, to make sure that the government didn’t go after their property.
Uncompensated takings would also encourage corruption, as owners would be willing to pay large amounts of money to influence the government’s choice of which property to seize
If people value their own property more highly than “fair market value,” this type of corruption is still a risk with compensated takings, but on a much smaller scale.)

Posner, in “Economic Analysis of Law,” makes the additional point that if compensation were not required, the government might substitute land, which it could get for free, for other inputs, which are cheaper than land in reality, but more expensive to the government
He gives an example
Suppose the government has a choice of putting up a tall but narrow building on a small lot, and a short but wide building on a large lot
The market value of the small lot is $1 million, and of the large lot $3 million
The tall narrow building costs $10 million to build and the short wide one $9 million
In social costs, the short wide building costs $12 million and the tall narrow one $11 million, so society is better off with the tall narrow one
But if land is free to the government, it might seize the larger lot and build the short, wide building.

The restriction of takings to be only for public use similarly discourages the government from abusing this power
Suppose I own a home, which has a fair market value of $100,000
But I’ve lived there a long time and grown accustomed to it and value it at twice that much.
Along comes a developer who wants to build something else on my land, and values the land at $150,000
Clearly, selling my land to the developer is not efficient, and would not occur on its own
But if the government could take private land for any purpose, it could force me to sell for $100,000, then turn around and sell the land to the developer for $150,000, keeping the difference
Or it could simply force me to sell to the developer for $100,000, in which case the developer would obviously be willing to go to great lengths (such as paying any sum up to $50,000) to make this happen.
The whole notion of Coase was that we should let people negotiate on their own to reach efficiency; by making transactions involuntary
Takings go outside this framework, and so should only be used as a solution to a clear problem, such as the provision of private goods.

Aside from the possibility of forcing a trade that isn’t efficient, there is another reason overuse of takings is undesirable: it creates uncertainty
We said before that when property rights are clearly enumerated and unambiguous, this effectively lowers transaction costs and helps people bargain to efficient outcomes
On the other hand, if government takings were very common, this would create a great deal of uncertainty
if you’re considering whether to buy new property, you don’t know whether you will get the full benefit of it, or whether it will instead get seized by the government
This may make it harder to transfer property to the owner who values it most
(We’ll come back to this point.)

Given the potential for abuse, and the negative effects caused by uncertainty when takings are overused, Cooter and Ulen suggest the principle that governments should only rely on takings when they cannot be avoided
That is, in their words, “the government should only take private property with compensation to provide a public good when transaction costs preclude purchasing the necessary property.”

The “just compensation” restriction on takings is fairly uncontroversial