Joe Mahoney University of Illinois at Urbana-Champaign

1. Economics, Organization and ManagementChapter 9: Ownership and Property Rights Joe Mahoney University of Illinois at Urbana-Champaign

2. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management Chapter 9: Ownership and Property Rights • The Concept of Ownership • Economic analyses of ownership have concentrated on two issues: • The possession of residual decision rights; and • The allocation of residual returns.

3. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • The concept of ownership is complicated even for simple physical assets. A person who owns something has certain rights and obligations concerning its use. • For example, if you own a car you are free to drive it (provided that you have a valid driver’s license and you obey the traffic laws), to park the car (in a legal parking space), to paint the car (provided that you keep the windows clear), to choose where and how often to have it serviced (provided the you obey the omission control and safety laws), to lend it to others for driving (if the borrower is a licensed driver), to transfer your rights to another party through sale, and so on.

4. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • If you own a company you have the right to: • Hire and fire its employees (subject to legal limitations on discrimination and wrongful discharge and the terms of any employment contracts; • Determine the products, prices, and policies of the company (subject to regulation); • Transfer the profits or other resources of the firm to your own personal account (subject to the tax laws and any restrictive clauses in the company’s loan agreements or other contracts, and so on).

5. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • For economic analysis, it is often useful to interpret “owning an asset” to mean having the residual rights of control – that is, the right to make any decisions concerning the asset’s use that are not explicitly controlled by law or assigned to by another contract. • If ownership means having residual control, then its importance must derive from the difficulty of writing contracts that specify all the control rights.

6. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Although the notion of ownership as residual control may be relatively clear and meaningful for a simple asset like an automobile, it gets much fuzzier when applied to something complicated, like a large organization. • Large organizations bundle together many assets and who has rights what decision rights may be ambiguous. Just what rights have been contracted away and to whom? An incomplete contract may be unclear on this point. For example, do the directors of the firm have a right to decide to accept a takeover offer without soliciting competing bids?

7. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Residual Returns • One conceptual way to think of the owner is the residual claimant --- the one who is entitled to receive any net income that the firm produces. That is, the owner is entitled to whatever remains after all the revenues have been collected and all debts, expenses, and other contractual obligations have been paid. Net income is conceived of as the residual returns --- the amount that is left over after everyone else has been paid.

8. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Like residual control, the notion of residual returns is intimately tied to contractual incompleteness. Under complete contracting, the division of the wealth in each eventuality would be specified contractually, and there would be no economic returns that could usefully be thought of as residual. • Just as the allocation of residual control can be fuzzy in the case of the firm (since the decision rights may be poorly specified), the notion of residual returns is fuzzy as well. • Under some circumstances, lenders are residual claimants • Managers and workers are residual claimants

9. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Pairing Residual Control and Returns • When it is possible for a single individual to both have the residual control and receive the residual returns, the residual decisions made will tend to be efficient ones. • In contrast, if only part of the costs or benefits of a decision accrue to the party making the decision, then that individual will find it in his or her personal interest to ignore some of these effects, frequently leading to inefficient decisions.

10. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Properly combining the two aspects of ownership --- residual control and residual returns --- provides strong incentives for the owner to maintain and increase an asset’s value. • Alchian and Demsetz (1972) treat the essential nature of the firm as a matter of creating this linkage. They consider a situation with team production, in which the output is the joint product of several workers’ contributions and the output attributable to any individual are difficult to define and certainly hard to observe. This creates an incentive problem of shirking.

11. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • An economic solution is for one member of the team to undertake a specialized function --- to monitor the other workers and to have the authority to expel members of the team who perform unsatisfactorily and replace them with new members. • The next question then becomes: “who will monitor the monitor?”

12. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Alchian and Demsetz (1972) solution is for the monitor to be motivated by receiving the residual returns. • The result is what economists call the classical firm --- an organization in which a boss hires, fires, and directs workers who are paid a fixed wage. The boss receives the residual returns. • Notice that this form of organization can only emerge if property rights are tradeable; it must be possible to assign residual control and residual returns to the person best suited to be boss.

13. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • The Coase Theorem • The Coase Theorem states that if the parties bargain to an efficient agreement (for themselves) and if their preferences display no wealth effects, then the value-creating activities that they will agree upon do not depend on the bargaining power of the parties on what assets are owned when the bargaining began. Rather, efficiency alone determines the activity choice. The other factors can affect only the decisions about how the costs and benefits are to be shared.

14. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • The Coase Theorem Reconsidered • The premises that people can bargain, implement, and enforce their agreements are not automatically valid. There can be significant transaction costs that arise from bounded rationality, private information, and unobservability of actions. Fully value-maximizing agreements, therefore, may not be reachable. • Another set of problems may prevent efficient agreements. These problems have to do with whether there are clear, enforceable property rights that can be transferred easily. If they are not then there is inefficiency.

15. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • The Coase Theorem Reconsidered • If property rights are not tradeable, then there is little hope that assets will end up with those people who can make the best use of them and so value them the most. If property rights are not secure, then owners will not invest great amounts in assets that they may lose with no compensation, or they may sink valuable resources into protecting their claims. • The reluctance to invest when property rights are insecure results in inadequate maintenance and development of assets.

16. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • The Coase Theorem Reconsidered • There is some suggestion that the threat of government expropriation without adequate compensation has hindered investment and development in parts of the Third World.

17. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Ill-Defined Property Rights and the Tragedy of the Commons • One of the saddest economic incentive problems resulting from untradeable, insecure, or unassigned property rights is known as: • the common-resource problem, • the public-goods problem, • the free-rider problem, and • the tragedy of the commons.

18. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Ill-Defined Property Rights and the Tragedy of the Commons • The idea is that when many people have the right to use a single shared resource, there is an incentive for the resource to be overused and, correspondingly, when many people share the obligation to provide some resource, it will be under-supplied. • When the residual returns to an asset are widely shared, no one person has a sufficient interest to bear the costs of maintaining and increasing its value. In such a cases, concentrating the ownership rights can lead to increased efficiency. • Fishing rights provide a good example of this phenomenon.

19. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • Ill-Defined Property Rights and the Tragedy of the Commons • When transaction costs are low, the Coase Theorem holds that the initial assignment of property rights is irrelevant, so long as the rights are clearly assigned, secure and transferable. • When there are significant impediments to efficient bargaining, however, it may be crucially important that these property rights be assigned properly initially. Otherwise, with little prospect of private bargaining reassigning these rights effectively, they can end up being very badly allocated. • If the initial allocation of property rights does affect economic value, then one possible objective for the law of property rights is to assign them in a way that creates value.

20. Milgrom and Roberts (1992): Chapter 9 Economics, Organization & Management • General Principles of Property Rights • Ownership rights should be structured with a concern to minimize the distortions in investment decisions caused by the hold-up problem. • Other things being equal, strong complementary assets (e.g., co-specialized assets) should be brought under common ownership.