Property Rights and the Role of Incentives

Defining property rights can sometimes help groups of people solve problems. Property rights are the rights of legal ownership of a certain resource or property.

When you own a tree that’s throwing shade onto another property, that’s legal shade-throwing from one neighbor to another. The shade is an example of what we call an “externality”...a side effect from one party’s activity that affects another. If the shade is considered a bonus (nobody likes skin cancer), it’s a freebie, something they didn’t pay for, but are glad to have anyway, i.e. a “positive externality.” If the shade is considered a problem by the neighbor...like, if they wanna get their tan on...it’d be considered a “negative externality.”

We usually focus on negative externalities, since people...don’t like them. A common example of a negative externality in economics is when factories pollute nearby residential areas, whether by making the air quality horrible, or leaking chemicals into groundwater, which results in early deaths and/or jaw-dropping medical bills.

Positive externalities are important too, since they can result in moochers...mooching. If you’ve ever put more than your fair share of work into a “team” project, you know the feeling. You work hard, only to see other people taking credit that’s not deserved. We call this the “free rider” problem, where one group gets benefits without paying any costs for those benefits, which fall on someone else. We’ve all been there...on one side or the other.

Negative and positive externalities both cause what we call “deadweight loss,” which measures how inefficient things are for society. We’d prefer no deadweight loss, which would mean that everyone’s paying for what they’re getting. People who have to deal with negative externalities would get paid for it, and people with positive externalities would pay for the freebies they’re getting. When it’s clear what belongs to who, it’s easier to work out externality problems. Like...the problem of the chocolate river use in Willy Wonka’s Chocolate Factory.

One group of Oompa Loompas, the Choco-Loompas, make chocolate, which requires the chocolate river. Another group of Oompa Loompas, the Gobstopper-Loompas, use the chocolate river for transportation. The Choco-Loompas don’t like that the Gobstopper-Loompas are using the river, since they’re polluting it. That pollution is a negative externality for the Choco-Loompas. The Choco-Loompas feel like they were minding their own business...just making chocolate, you know, as they do...and then the Gobstopper-Loompas started polluting the river. They have to take extra time and money to clean the pollution out of the chocolate river, which they don’t think is fair. Another reason the Choco-Loompas are mad is that the Gobstopper-Loompas are just using the river as transportation, for free. Where the Choco-Loompas see a free rider problem, the Gobstopper-Loompas see a positive externality. As long as nobody says anything, polluters are incentivized to keep polluting without paying for it, and moochers are incentivized to keep mooching.

At the Oompa Loompa lunch hall, things got...tense. Before violence broke out, one Oompa Loompa (who works with the squirrels) said, "You guys should just set property rights, so Mr. Wonka doesn’t have to get involved again." And... that’s just what they did. The Oompa Loompas all agreed that the Choco-Loompas should have the property rights to the river, and that the Gobstopper-Loompas should pay to use (and pollute) the river. The fees paid went toward paying for the pollution-filtering of the chocolate river, i.e. the negative externality. The fees accounted for them using the river was a positive externality, too. Since the Gobstopper-Loompas had to actually pay to use the river now, they were more conservative with how they transported their Gobstoppers, resulting in less pollution in the river for the Choco-Oompas to filter out...as well as the money to pay for it, resulting in an efficient market outcome.

This is an example of how private property rights can solve externality problems without public solutions. Public solutions are government interventions, like the popular “cap and trade,” for example. For a quick recap on cap and trade: cap and trade is where the government steps in and puts a cap on a type of pollution, letting companies pay-to-play. These companies can pay for their pollution “credits,” and trade these pollution credits amongst themselves. Many economists like cap and trade, since it creates a marketplace for pollution, letting the invisible hand do its job. They also like it since it lets the government set a maximum amount of pollution allowed to be created. But cap and trade requires the “cap” part to be enforced by the government; otherwise, companies will just keep polluting, ignoring the rules that they need credits to pollute, and it doesn’t work.

The idea that you can internalize an externality with property rights and no need for government intervention is thanks to Nobel Prize winner and very-smart-human Ronald Coase, and is named the “Coase Theorem.” Under the Coase Theorem, it doesn’t matter to whom property rights are assigned, as long as they’re assigned to someone. Then poof...no more externalities. Unfortunately, The Coase Theorem of setting property rights to get rid of things like negative externalities doesn’t always work. For instance, it’s easy to assign property rights to a river...but what about to the air? Pollution starts small, then spreads, all the way across the globe. No one owns the air, so...yeah. This is what we call the assignment problem: when it’s hard to assign property rights to a thing.

There’s also something called the holdout problem. What if some of the Oompa Loompas were stubborn and couldn’t reach an agreement on what to do? When there’s shared ownership, there’s the potential for someone in the group to “hold out” because they disagree with everyone else.

There’s something else that happens sometimes when you try to use property rights to fix things: transaction costs and negotiation issues. The Coase Theorem assumes that negotiating doesn’t cost anything. Big corporations might have the time and money to go through court to settle disputes about the pollution they’re causing...and not paying for...but families don’t. Which is why class action lawsuits are a thing: transaction costs are real, and can be a serious barrier.

When there are problems like the assignment problem, the holdout problem, and too-high negotiation costs, we turn to public solutions over private solutions to solve externality problems.

If only things were as simple in the real world as they are in Willy Wonka’s Chocolate Factory. Provided you keep away from the squirrels, of course. They’ll getcha.