Property rights and transaction costs in developing countries: A political settlement perspective

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Photo by Dennis Jarvis. Louisbourg Lighthouse.

Transaction costs due to distributional conflicts, political settlements, and weak enforcement capacity have important implications for the implementation of property rights in developing countries. While critical analysis of these factors is missing in the mainstream economics approach to property rights, it is obvious that incorporating such analysis will be crucial in designing policies to minimize transaction costs that hinder an efficient functioning of property rights. Specifically, there is a need for an alignment of interests among powerful political and economic interests if property rights are to be more efficient at reducing transaction costs. 

A fundamental limitation of contemporary property rights theory is its inability to incorporate factors that might reduce property rights from solving transaction costs, particularly in developing countries. This piece reviews the mainstream explanation of the relationship between property rights and transaction costs and then evaluates factors that can inhibit property rights from reducing relevant transaction costs, which include distributional conflicts, costly enforcement capacity, political settlement, and measurement problems. Major emphasis is placed on social conflicts and organization of power which are missing from the conventional analysis of property rights.

In this respect, the political settlements framework developed by SOAS economist Mushtaq Khan can enrich our understanding of the operations of property rights in developing countries. Khan (2018) defines political settlements as “social orders characterised by distributions of organizational power that together with specific formal and informal institutions effectively achieve at least the minimum requirements of political and economic sustainability for that society”. In short, political settlement means the distribution of power among different groups.

The origins of the mainstream view of property rights 

It is widely believed that John Locke was the first great thinker on property rights, owing to his influential work, Two Treatises of Government, which made a passionate argument for inalienable rights to life, liberty, and property, as well as the limited but crucial role of the state in the enforcement of such rights. However, Locke failed to critically appreciate significant transaction costs associated with the operation of these inalienable rights, such as the cost of getting people to agree on the allocation and outcomes of property rights and the cost of their enforcement. This systematic relegation of the role of critical factors that create transaction costs within the context of property rights seems to resonate with the assumption of zero transaction cost in neoclassical economics. For instance, in the world of Robinson Crusoe, it is assumed that agents can interact in markets to exchange at zero transaction cost due to well-defined property rights (Starr, 2011).

New institutional economics (NIE) theorists introduced the role of transaction costs and property rights into economic analysis, especially with regards to the analysis of externalities and market failures (Coase, 1960). This new strand of literature also led to advancements in the economics of property rights, exploring how the structure of rights affects not only the workings of a market system but also influence the allocation of resources and economic performance historically (North, 1981; Alchian & Demsetz, 1973). At the heart of this literature is the belief that private property rights eliminate transaction costs associated with primitive communal ownership of assets by solving collective action problems such as free riding, moral hazard, and tragedy of the commons.

Why Are Property Rights Thought to Reduce Transaction Costs? Unpacking the Theory

In the conventional theory developed by Demsetz (1967) and Alchian and Demsetz (1973), property rights are assumed to spontaneously emerge as a result of interacting agents responding to new or different forms of technologies and market opportunities that create social benefits and costs. Further, it is posited that the likelihood of adopting a different property rights system depends on the relative costs and benefits of internalization of relevant externalities such that the higher the costs, the lower the prospect of achieving property rights change (Milanokis & Meramveliotakis, 2013). This theory of property rights is outlined in Demsetz (1967), using anthropological findings from the New Continent, as follows. 

In the ancient Montagnes society in Quebec, the hunting of beaver was for consumption purposes with no significant overkilling that would deplete the stock of beavers in the forests. However, in the 18th century, commercial trade in fur opened up, which increased the relative price of beaver fur leading to overhunting among the native Montagnais because their communal ownership system lacked the incentive to ensure sustainable hunting practices. Eventually, rights on land became institutionalized, which motivated the Montagnais to internalize their externalities and consider social consequences of their activities. Therefore, establishing property rights solves the inefficiencies associated with communal ownership.

However, it is worth noting the inherent assumptions about transaction costs that form the cornerstone of the above theory. Most importantly, Demsetz (1967) assumes that communal ownership cannot be relied upon to solve externalities problems due to prohibitive transaction costs associated with it – for example, the costs of organizing the community members to agree on an efficient hunting regulation, enforcing contracts, and monitoring to ensure adherence. In other words, reaching an agreement based on a collective communal decision will involve significant ex-ante and ex-post arbitration and monitoring costs, and Demsetz found it “difficult to see how the existing communal ownership can reach an agreement that takes into account of these costs” (1967: 355).

The most desirable solution, therefore, is the enactment of exclusive private rights that eliminate such transaction costs and allow individuals to make quick, efficient decisions about their assets. There are several ways in which property rights are thought to function to reduce transaction costs, thus driving efficiency and growth (Khan 2009). First, property rights tend to enable investors to have security over their assets which incentivize them to make crucial decisions over long term horizons. With low expropriation risks to asset owners, optimal decisions can be made at negligible transaction costs, thus avoiding the tragedy of the commons and inefficient use of scarce resources. Second, Coase theorem proposes that property rights can facilitate the efficient transfer of assets via voluntary exchange. When rights are well-defined, agents can easily negotiate terms of trade and assets will be allocated to their highest valued use irrespective of the nature of the initial allocation of rights (Coase, 1960). A potential problem with this claim is that the nature of the assignment of property rights can influence the outcomes of exchange, often involving transaction costs which inhibit optimal resource allocation (Libecap, 2004). This appears to indicate that some costs have to be incurred before reaching compromise among interacting parties, which is often prevalent in developing countries. Moreover, the Coasian proposition would breakdown in the absence of compulsion to enforce an efficient transfer of properties among individuals.

Third, according to Alchian and Demsetz (1972), property rights can reduce transaction cost by diminishing incentives for freeriding or shirking within an organization, leading to efficiency and productivity growth. This view suggests that creating exclusive rights to specific actors (residual claimants) within a firm will lead to faster decision making, as well as create incentives and compulsion for efficient monitoring of workers to tackle shirking in a team, thus raising the productivity of a firm. But a deep problem related to this theory is its lack of convincing explanation as to how team members will collectively agree on a residual claimant – obviously, significant transaction costs will be incurred in getting members to agree on who will become a residual claimant and on terms of the distribution of benefits. Similarly, it ignores the possible transaction costs of re-negotiating the terms of the distribution of output that might come about overtime between workers and residual claimants due to factors such as changes in relative prices or external competition. It seems implausible to assume that voluntary arrangements formed within team production will last forever without any transaction costs arising from demands for higher wages or renegotiation of contracts by the workers. 

An Alternative Approach: The Importance of Political Settlements

Khan (2009) argues that the above explanation is fundamentally inadequate because transitioning from communal to private ownership systems can also involve substantial “transition” costs and such a transition is not that simple. Specifically, creating new rights or modifying existing rights will involve winners and losers who will organize themselves to block any new innovations through difficult and costly negotiations or violent contestations, thus involving significant transaction costs (Khan, 2009). In addition, there can also be considerable transaction cost associated with monitoring the enforcement of private property rights which is assumed away in the theory by Alchian and Demsetz.

The above issues, among others, underline the importance of political settlement (distribution of power) in property rights. While Khan (2009) introduced political settlement as a framework to analyze property rights, his analysis focused on the growth-stability trade-off relating to the governance of efficient property rights regimes in developing countries. He argues that when there is an asymmetric distribution of power among disparate groups, the associated transaction costs cannot be simply overcome by property rights. For example, consider the case of recurrent clashes between sedentary farmers and herdsmen in Nigeria despite it being clear that the farmers have property rights over their land and should be free from incursion by the herdsmen. This long-standing tension has resulted in an enormous loss of lives and properties, and complex negotiations at different levels (Salihu & Guariso, 2017). 

What explains the inability of property rights to reduce transaction cost here is partly the relative organizational power of herdsmen over the farmers, both in terms of physical resources and ability to mobilize support to defeat the farmers in most conflicts. Moreover, it appears that the herdsmen have extensive patronage from some Nigerian Fulani elites (such as traditional rulers and politicians) who block the passage of a legislative bill to establish ranching area as a solution to the recurrent conflict. Thus, political settlement can get in the way of making property rights work efficiently to reduce transaction costs.

Unlike the conventional theory, the political settlements framework embraces the role of the state and other non-state enforcement actors, which are not only crucial to the emergence of property rights but can also involve significant transaction costs in their own ways. For instance, if the interest of the enforcement agency is not aligned with the creation of growth-enhancing property rights or if it is being influenced by parties opposed to the institution of rights, then property rights might be created but transaction costs would remain high. On the one hand, transaction cost might take the form of wasteful use and allocation of resources (for example acquisition of physical resources to undermine rights or resources channeled to bribing the enforcement agency) by those groups who would lose out due to property rights. On the other hand, parties who would benefit from property rights would also incur costs in their bid to secure their rights through an unproductive commitment of resources for personal protection or for lobbying the agency to be efficient in enforcing property rights. 

The political settlements perspective is also permeable to issues of human identity as it is not entirely predicated upon cost-benefit analysis of a rational agent as assumed in the conventional theory. According to Alchian and Demsetz (1973), once gains from exchange are high relative to the costs of exchanging, agents will willingly give up their property rights over assets in exchange for something at insignificant transaction costs. However, this simple view ignores some fundamental issues regarding identities and human nature that can make the transfer of assets very difficult even when property rights are well delineated. A good example is a fierce resistance by powerful indigenous landowners and peasants to attempts at land grabbing or reforms, resulting in transaction costs that can transcend far beyond material losses to killings and social uprisings (Hall et al., 2015). Research has shown that a large number of the people who take part in resistance do so not because they don’t appreciate the compensations on their lands or assets but because they are simply unwilling to surrender those assets due to historical ties, cultural significance, and degree of holding power. 

References

Alchian, A. A., & Demsetz, H. (1972). Production, Information Costs, and Economic Organization. American Economic Review, 62(5), 777-795.

Alchian, A. A., & Demsetz, H. (1973). The Property Rights Paradigm. Journal of Economic History, 33(1), 16-27.

Coase, R. H. (1960). The Problem of Social Cost. Journal of Law and Economics, 3, 1–44.

Demsetz, H. (1967). Towards a Theory of Property Rights. American Economic Review, 57(2), 347–359.

Hall, R., M. Edelman, S.M. Borras Jr., I. Scoones, B. White, and W. Wolford (2015). Resistance, Acquiescence or Incorporation ? An introduction to land grabbing and political reactions ‘from below.’ The Journal of Peasant Studies, 42(3–4), 1–22. 

Khan, M. H. (2009). Governance Capabilities and the Property Rights Transition in Developing Countries. London: Department of Economics, SOAS University of London.

Khan, M. H. (2018).  Power, pacts and political settlements: A reply to Tim Kelsall, African Affairs,  117(469), 670–694.

Libecap, G. D. (2004). The Effects of Transaction Costs in the Definition and Exchange of Property Rights: Two Cases from the American Experience. In E. Colombatto (Ed.), The Elgar Companion to the Economics of Property Rights (pp. 108–129). Cheltenham: Edward Elgar Publishing.

Milanokis, D., & Meramveliotakis, G. (2013). Homo Economicus and the Economics of Property Rights: History in Reverse Order. Review of Radical Political Economics, 45(5).

North, D. C. (1981). Structure and Change in Economic History. London: W. W. Norton 7 Company.

Salihu, M., & Guariso, A. (2017). Rainfall inequality , trust and civil conflict in Nigeria Rainfall inequality , trust and civil conflict in Nigeria (Economics Working Paper Series No. 29). Lancaster.

Starr, R. M. (2011). General Equilibrium Theory: An Introduction. New York: Cambridge University Press.

Abdulrasheed Isah is an Assistant Lecturer in Economics at Nile University of Nigeria, Abuja. @Madari2fourIsah

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