CHAPTER 3
3.1 INTRODUCTION
The previous chapter goes some way to describing the central advantages of the market process. Efficient resource allocation is achieved as if all decisions were guided by an invisible hand. The analysis is instructive. Push most conservatives and sooner or later their position will rest on the advantages of the market process. The discussion is, however, incomplete. Taken at face value the message of Chapter 2 seems to be that there is no role for political agents. Let the market do it, seems to be the catchcry. And to be sure the market will handle the production and exchange of goods and services in an appropriate manner. Individuals will be able to buy the refrigerator or toilet paper of their liking and in so doing, improve their feeling of well-being. By the same token, firms are willing and able to allocate resources in such a manner as to produce a sufficient number of fridges or so-called "green" products to satisfy demand. Following changes to the demand for fridges, say due to the greenhouse effect, there is no need for the government to decree to the producers that they must build more fridges. Producers, in their pursuit of profits, will employ more resources to meet the increased demand. But this goes too far. There is a role for government. The market process will collapse without the benefit of the intervening hand of government.
3.2 THE ROLE OF GOVERNMENT IN RESOURCE ALLOCATION
3.2.1 Static resource allocation
Indeed, a crucial role to be played by the government is the enforcement of the "rules of the game". In order for this voluntary exchange of refrigerators for money to take place unimpeded, individuals need to be secure of their property rights. For example, the individual who walks into a retail outlet must believe that the shopkeeper will not be allowed to simply take the money from his wallet. The choice to part with the money must lie in the hands of the purchaser. By the same token, the choice to part with the fridge must remain in the hands of the retailer. The government's role in this voluntary exchange is to protect these entitlements by means of the judiciary and the police force.
Since the notion of property rights features widely in this work, it is useful to explore the concept in some depth. Suppose an individual acquires a licence to open a shop. Alternatively, imagine that a company acquires a licence to mine a certain tract of land in the outback. It is all too easy to draw the conclusion that these individuals have acquired a valuable asset. The value in use of these items is dependent, however, on what the individuals are entitled to do with these assets. Suppose, for example, that although the mining company has an exclusive right to mine the land, it has no entitlement to sell the output on either the domestic or the international market. In such a setting, the licence to mine the land would be virtually worthless. Alternatively, suppose that the licence to operate the shop prohibits the store from being opened over the weekend period. Here individuals would place a lower value on the licence than in the case where they had the option themselves to decide on their shopping hours. It is, therefore, worth bearing in mind that what individuals are acquiring are bundles of property rights rather than inanimate objects. A property right is a multi-dimensional concept. A property right specifies (a) the form of ownership, (b) the uses that may be performed, and (c) the forms of transferability that may take place with a resource.
Take the case of your motor vehicle. The law specifies that any individual may hold an entitlement in a motor car; the privilege is not restricted to some specified group of individuals. This would not be true if we had taken instead automatic assault weapons as our example. In this case, ownership is restricted to particular groups such as the armed forces and police departments.
With respect to use, you have a private property right if your decisions about the use of the asset dominate those of all other individuals. In the case of the shop operator, he has the private right to determine what prices he will charge. He is not restricted to some retail price maintenance scheme set in place by the manufacturer. Take the case of your automobile. You do not need to ask your neighbours, for example, whether or not you can drive your car down to the local corner shop, and your neighbours must first seek your permission if they wish to borrow your car. Your car is not some form of common property (10) or open access resource like international waters where anyone can avail themselves of the resource. Nor do you have to seek the permission of the government to drive your car to the country on a Sunday afternoon. It is not some form of social property right.
It is clear, however, that you do not have unrestricted right of use. Your right is attenuated by certain government laws. The Traffic Code specifies that while you may drive your car on a public road if your car is roadworthy and licensed, you must not, for example, exceed a certain speed. Nor do you have the right to drive your car across double lines. You must drive on the appropriate side of the road. You do not have the right to drive your car through your neighbour's fence.
Finally, property rights encapsulate how assets may be transferred. In the case of your motor car, you are free to sell it on the used-car market. The law merely specifies what procedures must be carried out so that the exchange is recorded appropriately. In some cases, individuals cannot transfer their rights to some other individual. The rights of citizenship, for example, cannot be legally bought and sold on the market.
So far, we have argued that the government's role in the market process is indirect, aimed at designing and maintaining the appropriate institutional structure. The government may, however, have a more direct role to play in other situations. Consider, for example, the case of so-called externalities or neighbourhood effects. Here, the market outcome may be improved upon by government action. A classic example of an externality is based on Coase (1960) and further illustrated by Gifford and Santoni (1979, pages 38-40). Suppose there are two farmers that have contiguous unfenced plots of land; one grows crops, while the other raises cattle. The cattle have a tendency to stray and destroy part of the crops in the process, and this damage increases as the grazier increases the size of the herd. For the sake of simplifying the argument, Gifford and Santoni introduce the following arithmetical example, which is reproduced in Table 3.1. In the absence of well-defined property rights, the grazier would maintain a herd size yielding the maximum profit. He would run 14 head of cattle and make a profit of $112. The farmer's loss as a result of the grazier's decision is $15. This loss represents the size of the external cost imposed on the farmer by the grazier. The net benefit to the collectivity is $97, which represents the gain to the grazier minus the loss to the farmer.
It is clear from the figures in the fourth column of the table that it would be possible to raise the collectivity's net benefit by reducing the size of the herd. Indeed, if the grazier could be somehow persuaded to hold only 12 head of cattle, then his profit would be $109, the farmer's loss would be $6, yielding a net benefit of $103. This outcome is referred to in economics jargon as the social optimum -- the outcome associated with the largest net benefit to the collectivity. As it stands, the grazier has no incentive to reduce the size of his herd, as this would result in a loss of profits of $3.
One way to achieve the social optimum is for the government to specify the rights pertaining to the use of the land. It can either allow the grazier to let his cattle graze without restrictions, or it can give the farmer the right to be free of straying cattle. In the first case, the grazier would simply choose his profit maximising herd size of 14. If the farmer and the grazier get together, however, it turns out that they can gain from trade. The grazier can be induced by the farmer to reduce the herd size. The farmer would be willing to pay up to $5 if the grazier reduced his herd by 1 head from 14 to 13. If the farmer pays exactly $5 then he is equally well off as a result of this move. If, however, the grazier accepts say, $4, then the farmer is better off by $1. He has paid $4 in order to reduce his crop losses by $5. The grazier is willing to accept anything equal to or above $1, because the herd reduction reduces his profits by $1. If he were paid $4, then he would be better off by $3. Using the same reasoning, the farmer would be willing to keep trading rights with the grazier until the herd size is 12. Although the farmer sustains a crop loss of $6 at that point, there are no further gains to be had from trade. This is because he would have to pay at least $4 to the grazier in order to reduce the herd to 11 and reduce his loss by a further $3. Clearly, this is not economically rational.
The remarkable point is that the trade between the farmer and the grazier has yielded the social optimum. It was not necessary for the government to wield its heavy hand in the form of taxation or regulation, in order to obtain this result. All that was necessary for the government to do was to clearly specify who had the rights pertaining to the use of the land.
The same result would have been achieved had the right been assigned to the farmer. In that case, the farmer would have the right to be free from all strays and his choice would be for the grazier to run no more than 9 head of cattle, since his crop loss would be reduced to the minimum at that point. The grazier has an incentive to bargain with the farmer in this situation. In order to be allowed an extra head of cattle, he would be willing to spend up to $6, which would more than compensate the loss to the farmer which is $2. Obviously, there are gains to be had from trade. The trading would continue up to the point where no further gains can be attained. This occurs at a herd size of 12, which is of course the social optimum identified above.
Irrespective of the government's initial assignment of the property rights, the social optimum has been achieved. It is important to the subsequent discussion to bear in mind that the distribution of income is affected by the government's decisions. In the first case, for example, the grazier was assigned the initial property rights and the farmer had to pay the grazier in order to reach a better outcome for himself. Suppose for the sake of argument that the farmer paid $7 to the grazier in order to get the cattle size down to 12. The grazier's income has clearly risen from $112 to $116 (being $109 profit plus $7 compensation). Although the level of the farmer's income is not given here, it is clear that his income has risen by $2 (being the reduction in crop losses of $9 minus his pay-out of $7).
If the assignment of property rights had been the other way around, then the distribution would favour the farmer. Suppose that the grazier paid the farmer $12 in order to be allowed to hold 12 head of cattle, then his income would only be $97 (being $109 profit minus the compensation of $12). The farmer's income would have increased by $6 (being $12 pay-out minus $6 crop losses).
Economists by and large worry only about achieving the social optimum, relegating these distributional effects to their more philosophically inclined colleagues. This occurs because economists feel that questions of resource allocation and efficiency are more objective than the value-laden questions about what the appropriate distribution of income is. As we shall argue below in Chapter 5, however, the distributional issue does have important ramifications for issues concerning efficient resource allocation.
Returning to the example of the grazier and the farmer, the issue at hand can be best captured with the aid of Figure 3.1. The vertical and horizontal axes represent the farmer's and the grazier's income respectively. The curve AEFB represents the collectivity's income possibilities curve. (11) For each level of income for the grazier, points on this curve denote the maximum income possible for the farmer. Points along EF are often referred to by economists as efficient outcomes. Only combinations within the area OAB can be attained, and points outside that area are physically impossible to attain.
In the farmer/grazier example, the original situation before assignment of property rights is denoted in Figure 3.1 as point C. The income of the grazier is $112 and that of the farmer is OD. Since point C lies within the area OAB, it is possible to improve the farmer's income without making the grazier poorer, that is, the move from C to E is possible. By the same token, the grazier can be made better off without harming the farmer's income, that is, the move from C to F is also possible. Of course, points E and F are the extreme cases and any point within the area CEF is preferred by both the farmer and the grazier. Points along the line segment EF represent those situation in which all the gains from trade have been exhausted.
By assigning property rights the government enables the move from C in a north-easterly direction by means of voluntary trade between the grazier and the farmer. Economists consider this to be relatively uncontroversial since neither individual involved could complain about the result -- they both end up at least as well-off as before the move. Neither individual chooses any particular point along EF. Rather, the outcome is generated by purely self-interested trading. The agents are driven by the famous "invisible hand" towards the new outcome. Matters become much more controversial, however, if the government should attempt to directly choose the outcome along the curve AB by using its "distributing hand". Any point along AE could be chosen by the government, through taxation or regulation, and it would represent an efficient outcome. Any point along AE will leave the grazier worse off as compared to point C. So by choosing such a point, the government is making the much more controversial judgement that the farmer ought to gain at the expense of the grazier. Note that this is not the case for points along EF.
In the examples given here, the role of the government has been a fairly passive one. It has protected and assigned property rights and that proved sufficient to provide the appropriate setting for voluntary trade. It is, of course, true that in some cases more drastic government action is needed. The examples we have already discussed worked because we implicitly assumed that the bargaining between the farmer and the grazier over the terms of the contract was inexpensive and free of the opportunistic behaviour identified in Chapter 2. These complicating factors fall under the general rubric of transaction costs.
A modification of the example of the grazier and the farmer can be used to illustrate the importance of transaction costs. Suppose that there is still one grazier, but that there are many small farmers on land adjacent to his. Here, each farmer can gain if there is a reduction in the herd size. Indeed, if one farmer bargains successfully with the grazier and the herd size is reduced, then all other farmers will benefit from this as well. If each farmer believes that he can obtain this benefit without paying any compensation to the grazier or contributing to a representative agent for all farmers, then no bargaining will occur and the social optimum will not be reached. This is known in economics as the free-rider problem. The transaction cost of organising the farmers to act as a collectivity are too high and cause the gains from trade to remain unexploited. The government may be able to overcome the free-rider problem and may achieve a better resource allocation by either taxation or regulation. Returning to the original farmer/grazier example, and assuming that transaction costs were too high for trade to take place, a tax of $2.10 per head of cattle would lead the grazier to adopt the herd size of 12, since at that point his after-tax profits (being $109 minus 12 times $2.10) are maximised. Compared to the earlier case without government action, the income distribution is different. The grazier's after-tax income is $83.80, the farmer's rise in income is $9, and the government's coffers are richer by the tax revenue of $25.20. Regulation specifying that the herd size is not to exceed 12 head of cattle would achieve an efficient outcome as well. Of course, all of this presumes that the government is omniscient and fair. The important point to note is that there can be a role for government in addition to protecting and enforcing property rights. We will take up the issue of imperfections in government's policies at a later stage.
It is also worth stressing that the government can, under certain circumstances, reduce the degree of waste due to transaction costs by initially assigning the property right to the individual who values the asset the most. In order to see what is at stake here, consider a slightly amended example of the farmer/grazier example. Compared to the previous case, the farmer suffers a lower loss at each herd size. An examination of the column of net benefits reveals that the social optimum occurs when the grazier runs 14 head of cattle. The level of net benefits to the collectivity is $108.50. It will be recalled that such a herd size is precisely the number of cattle that the grazier would run in order to maximise his own private profits. In this particular example, the private and social optima therefore coincide.
In order to appreciate the effect of transaction costs on the size of the collectivity's net benefit, consider the following setting. Assume it costs the grazier $5 if he enters into negotiations with the farmer. If the government assigns the property right to the farmer, then it is clear from the structure of the example that there are potential gains to be made from trade. The grazier stands to make a net profit of $107 if he can gain the right to run his herd (that is, a profit of $112 minus $5 worth of transaction costs) which is clearly greater than the profits he can gain if the farmer enforces his property right.
The farmer also stands to gain from the trade. The fanner's net gain from the exchange of property rights could be as much as $9.50. This amount represents the difference between the grazier's maximum willingness to pay, net of transaction costs, to run 14 head of cattle and the farmer's loss of $3.50. Given these limits, it is clear that in principle there exists some bargain that could be struck in which both individuals gain from the exchange.
It is all too easy to lose sight of the fact that the government's assignment of the property right to the farmer has dissipated some of the collectivity's net benefit from the two farming operations. The net benefit to the collectivity associated with a herd size of 14 is $103.50 -- the net benefit minus the transaction costs of achieving the reassignment of the property right. If the government had assigned the property right to the grazier in the first place, then the net benefits from the two economic operations would have been $108.50. The government can in principle avoid the dissipation of benefits by first assigning the property right to the individual who values the entitlement the most. In this way, the transactions costs associated with reallocating the entitlement to the grazier are avoided. (12)
It is important to bear in mind that the external effects discussed here are so-called technological externalities. The consequence of an individual's action is transmitted through the units of output (well-being) that can be obtained from an enterprise's (consumer's) resources. Pecuniary externalities result from a change in the price of some resource in the economy. The distinction is an important one in economics. While there may be a case for intervention to correct technological externalities, there is no case at all where pecuniary externalities are concerned. (13)
It is useful to illustrate these distinctions in terms of the example of the farmer and the grazier. Recall that the grazier's cattle strayed from his property and trampled some of the farmer's crop. This is an example of a technological externality. The actions of the grazier affect the amount of output that the farmer can obtain from his plot of land. The impact of this externality raises the social cost of producing steers. The analysis demonstrated that the individuals concerned should be induced by some institutional arrangement to take into account the cost of their actions on each other. One might believe that this situation is replicated exactly in the case of pecuniary externalities. Suppose that as a result of increased demand for fertiliser, the farmer experiences a rise in his costs. One might believe that government action is warranted here too, for the loss the farmer experiences from an increase in his costs would seem to be no different to the loss he experiences when his neighbour's cattle trample some of his crop. Both are surely equally annoying to the farmer irrespective of their source. Both result in an increase in the individual's cost structure. What is of crucial concern, however, is the source of the external effect. The change in costs to, say, the wheat farmer brought about by the change in input prices warrants no intervention since the external effect is an essential characteristic of the market process. A word or two of explanation is required here. Suppose the increase in the price of fertiliser arose as a result of sugar cane fanners increasing their demand for fertiliser. Sugar cane farmers had noticed that individuals in the market were willing to pay more for sugar. The increase in the demand for fertiliser increased its price and this had brought about the increase in the wheat farmer's costs. Intervention is not warranted here. The increase in the wheat farmer's costs means that he will cut back on his demand for fertiliser. This releases resources to be used in the sugar industry where they are of greater value. The pecuniary externality does not generate any misallocation of resources that would warrant any institutional reform. In fact, the change in price is required to provide a signal that resources ought to be redirected to other parts of the economy.
It is, of course, true that some individuals are made worse off as a result of this adjustment. At the very least, the wheat farmer will sustain a loss in profits. At the most, he may be forced to sell up and move off the land. Specialised factors used in the wheat industry will have their economic rents reduced too as a result of the cut-back in wheat production. There will be a painful period of readjustment. There is a cost to using the market system. And in order to ameliorate this cost, there may be some role for a welfare state. Yet whatever the aid, one thing is clear: farmers in the sugar industry should not be forced by any institutional change to take the wheat farmer's change of costs into account. Such a change would defeat the purpose of the market system.
Given the strong theoretical case for government intervention where technological externalities exist and transactions costs are too high, an interesting question arises as to whether the general principles advanced here are helpful in explaining current existing institutional and legal practices. Is it really the case that governments are observed to be allocating rights on the basis of who values the entitlement the most? Some highly influential scholars have taken the view that the general principle advanced here goes a good way towards rationalising some aspects of our legal code.
Ronald Coase (1988), for example, argues that the law against blackmail can be explained as a way of reducing the transaction costs associated with blackmail itself. If blackmail is made illegal, then some individuals will decide that the risks of, and costs associated with, this criminal activity outweigh the potential gains from blackmail. In this case, such individuals will turn their energies and resources to some other activity, thereby increasing the value of production in other areas of the economy.
The principle advanced here has considerable general applicability. Parents, for example, are assigned certain rights over the newborn child. They can take the child home and give it their name. Later, they can determine whether the child will go to a state or private school. There is no need for them to go through any costly process to claim that they, rather than some other adult, have the right to make such decisions. Such rights are given to the parents because a judgement has been made that they value the child's welfare more than some other adult; that efficient resource allocation is promoted by assigning these rights to the parents and not some stranger in the maternity hospital who happened to be passing by. The collectivity, therefore, avoids the waste that would occur if each parent had to go through the court system in order to establish that they had these rights of guardianship.
Or take another example. Individuals are assigned certain rights over their body. An individual's eyes are assigned to the person who presumably values them the most, the individual himself. The individual can decide whether or not he wishes to declare on his driver's licence that he is willing to have his eyes taken for a corneal transplant in the event of his death. The individual is assigned this right at low cost to the economy. He does not have to go through any costly court procedure in order to establish this right of use over his eyes.
Although this discussion goes some way to identifying the factors that ought to be considered when entitlements are initially distributed, it by no means spells out all the important factors. Reconsider the example of the farmer and the grazier. There it was argued that the property right ought to be assigned to the grazier since it is this individual who values the entitlement the most. In this way, the transactions costs which dissipate the return to the collectivity of the two farming operations would be avoided. The analysis relies on a certain epistemological premise. If it is relaxed, then the conclusion made about who ought to be assigned the entitlement is somewhat altered.
In truth, it may not be possible to specify who values the property right the most for precisely the same reasons that the planner could not identify who valued the eggs the most in the parable discussed in Chapter 2. Not all cases are as clear as who should be assigned the rights of guardianship over the new-born child or who has the right to determine whether his eyes should be used for some corneal transplant. It may be difficult to form any clear presumptive case of who values a particular property right the most. In a world in which transaction costs are positive and where individuals lack knowledge about other persons' willingness to pay, the task is to find a method of distribution that leads to an efficient initial allocation of resources. In this way, the needless waste associated with reassignment of the entitlement may be avoided. Will random distribution of the entitlements do the trick? Should individuals be asked to queue and the entitlement distributed to those first in line? The general issue of how entitlements can be assigned to those who value them the most is explored in depth in Chapter 4.
Another set of problems arises when the rights to use a resource are either so poorly defined or enforced that individuals are free to use the resource as they see fit. The resource belongs to no one and is free to be used by anyone. International waters surrounding Australia, for example, are owned by no particular individual or country. Any individual can exploit the fish stocks in those waters without the need to seek permission from any other individual or national government. Fishermen can use fishing techniques such as drift lines that are banned in domestic waters. A particularly striking example of these so-called "open access" or "common property" resources is the global environment. Since the atmosphere is owned by no single entity, it is difficult, if not impossible, for Australia on its own to exercise any control over the use (or misuse) of the resource. A moment's reflection about Australia's inability to stop France testing her nuclear weapons in the Pacific Ocean illustrates the point.
The phenomenon of open access resources can arise even when ownership is technically feasible. Consider inland waterways; these are owned by the state. Suppose the state government for whatever reason fails to monitor the regulations that apply to the use of the asset. In this case, the resource can be analysed as an open access resource despite the fact that there are restrictions on use.
In order to gain some appreciation of the problems (and indeed tragedies) that can arise with open access resources, it is useful to consider a simple economy. Let us suppose that there are two sectors and 20 workers in the economy. Half of them work on the land and receive a wage of $100 each. For simplicity's sake, suppose the wage in the agricultural sector reflects the value of output to the economy and that this return does not change as the number of workers in agriculture rises or falls. The other half of the labour force works in the fishing sector and brings back a catch worth $2000. Suppose the workers in the fishing industry are equally productive and thus each earns a wage of $200. The net social value of these two sectors to the economy is $1000. The individuals working in the fishing sector forgo the wage they could have earned in the agricultural sector and this represents the cost to the collectivity of their involvement in the fishing industry. This cost must be taken away from the value of the catch in order to derive a measure of the net social value of this activity to the economy.
Individuals who perceive the difference in the returns from the two sectors believe that they can improve their individual lot by changing occupations. An agricultural worker who has the opportunity to leave the land at low cost will expect an increase in his wages. Suppose the increased level of fishing effort results in an increased catch worth $2035. The eleven workers engaged in fishing now each earn $185. There are a number of points to be made about the analysis here.
Although the individual's decision to change occupations results in an increase in his own wages, it leads to a loss in the social value to the collectivity. The increase in social value arising from the entry of an additional worker in the fishing sector is $35. This gain comes, however, at the expense of a loss of agricultural output, equivalent to $100. The net loss to the collectivity is therefore $65. The economic rent arising from the use of the land and the sea will have been reduced by $65. In fact, the loss arising from the misallocation of resources will increase as workers in the agricultural sector who can leave the land at low cost continue to head for the sea in search of the relatively higher wage. The social value from fishing will continue to fall as the number of fishermen increases. The loss to the collectivity will therefore rise since the gap between what is gained from fishing and what is lost from agriculture will widen.
The source of the misallocation arises from the lack of well-defined property rights. The individual deciding whether to enter the fishing sector need only consider his own private costs and benefits. He will change occupations if there is an increase in his own income. That the other individuals in the fishing sector experience a fall in their wages as a result of his actions is of no interest to the individual. The individual is free to enter the industry; there is no social rule that encourages the individual to take into account the cost that he is imposing on his fellow workers.
The collectivity can improve the allocation of resources by restricting the number of individuals who can work in the industry. State authorities in Australia use a number of different methods to restrict the level of fishing effort, thereby avoiding the excessive entry that leads to the dissipation of rents. Some fisheries, for example, have short fishing seasons or year-round closure for one or two years. In other sectors, such as the abalone industry, individuals must purchase a licence before they can engage in the industry. A number of issues arise at this point. Should the state authority use regulations to restrict effort or should it limit the number of entrants by forcing potential fishermen to purchase a fishing licence? If the latter is chosen, then the question arises as to whether the authority ought initially to sell off these licenses or distribute them free of charge on the basis of, say, the individual's credentials. These issues are explored in Chapter 4.
3.2.2 Dynamic resource allocation
In the discussion so far, we have ignored the important role of time in the allocation of resources. Generally speaking, investment decisions by economic agents are made on the basis of current and expected future events. In order to illustrate the peculiarities that emerge in a dynamic setting, consider the following simple example drawn from Haddock (1986) and presented in a modified form here. A group of Eastern farmers is considering occupying land in the West. There is only room for one farm. The West has recently been experiencing a boom and therefore the Eastern farmers believe that the value of agricultural produce in the West will rise over time. Suppose that current and expected future earning streams for farms in the East and in the West are as given in Table 3.3.
Period t is the current period. Row 1 indicates that the return from agricultural output on a Western farm increases by $5 each year. Row 2 shows that the return value from agricultural output in the East is not expected to change. Clearly, from the viewpoint of the present (period t), it is optimal to keep farming in the East until period t+10, after which the farming in the West becomes more profitable. The decision to start farming in the West at period t+10 is optimal from the viewpoint both of the Eastern farmers and society. This is because the stream of agricultural output is maximised when the settlement occurs at period t+10. As the third row in Table 3.3 shows, switching in period t would mean giving up $200 from farming in the East in order to gain $150 in the West. Clearly, this is not economically rational. The same holds for any settlement date before period t+10, when it becomes just rational to switch from the East to the West. After t+10 the return from farming in the West outweighs the output lost by giving up farming in the East.
If the government does not intervene by assigning property rights, then it is likely that settlement of the West will not occur at the optimal time. The reason for this is that individuals will attempt to claim ownership of the farm in the West by settling there before any other claimants can do so. Suppose possession of the land in the West is determined on a first-come-first-served basis. In that case, it would be rational for risk-neutral farmers to settle in the West at the point where the present value of the net income stream of the farm in the West turns positive. Net income is defined as the difference between the present value of farming in the West minus the forgone present value of continuing to farm in the East. The figures are calculated on the basis of a series of time frames and have been presented in Table 3.4. The first figure in each row indicates the value of farming in the particular region from time period t. The second figure represents the present value of farming in the region as seen from time period t+1 and so on. (14) For example, the present value of a farm in the West if settled four years from now (period t+4) is $950 in period t+4 dollars.
As this table shows, the present value of the farm in the East is $975 five years from now.
The individual would not make a decision to move to the West in five years' time as he would sustain a loss of $25, as is indicated in the third row. At the beginning of year 6, however, the present value of the farm in the West has risen by $25 to $1000, and the two ventures are equally profitable. As the third row in the table indicates, the Western farm is more profitable than the Eastern farm thereafter. The Eastern farmer would decide now to move the West five years from now (at the beginning of year 6).
It is, of course, true that the farmer sustains a loss as a result of this premature settlement; the profit maximising date to begin farming in the West is ten years from now. The individual, however, cannot wait the additional five years. By then the land would have already been captured by someone else. This point is aptly mirrored in the adage that it is the early bird who captures the worm.
The individual's decision to settle prematurely has important implications for the use of the economy's resources. It is easy to see that the farmer's decision to move West in five years' time is not optimal from the viewpoint of the collectivity. In the analysis above, it was shown that if the objective is to maximise the return from agricultural land in farming as a whole, then farming in the West should only begin ten years from now. In fact, the farmer's decision to settle prematurely has dissipated the entire return from opening up farm land in the West. This is reflected in the fact that the discounted value of the losses of using land in the West prematurely (from period t+6 to t+10) just equals the discounted present value of farming in the West ten years from now into the future (from period t+11 to infinity).
The lost output as a result of the premature settlement of the West can best be illustrated with the aid of a diagram. Figure 3.2 depicts the income streams associated with the two farming prospects and corresponds to the figures underlying Table 3.3. The lines PW and PE denote the income streams associated with farming in the West and the East respectively. The socially optimal time to settle the West is at the end of period t+10 where the income stream from the West just matches that from the East. In the absence of government intervention, the privately optimal time to settle is at the end of period t+5. Then the net present value of the settlement is exactly equal to zero, that is, the present value of area ABC exactly equals the present value of area PWCPE. As a result of the early settlement, the present value of the area ABC is lost to society as a whole.
It may be possible to improve the allocation of resources through time by regulation that proscribed premature entry. In the example here, a simple regulation that no settlement should take place in the West until ten years have passed would appear to prevent the dissipation of rents. There are, of course, other methods that the government could adopt to prevent the dissipation of rents from premature entry. Since we intend to examine some of these methods below at length, it will suffice to mention merely some of the main alternatives.
The government could implement a tax on settlers so as to make it in the individual's interest to settle at a later date. Alternatively, the government could auction off the land today. Individuals would be assured of ownership as long as they were willing to pay the price. This would eliminate the need to settle early. The successful bidders would then continue to farm in the East, resulting in an improvement in the allocation of resources.
3.2.3 Comparative institutional analysis
Up to this point, the impression may have been created that failure of the market to allocate efficiently provides a prima facie case for government intervention. In the case of the externalities discussed above, government intervention was invoked in situations where transaction costs made the private market trade of entitlements prohibitively expensive. In the dynamic case of premature settlement of the West, once again government intervention was called for in order to improve resource allocation.
All of this is in keeping with the standard view of the public sector in economics. Government is modelled as a single, benevolent, omniscient "social engineer" stepping in where needed to correct the failures of the market. Of course, in reality the government consists of private individuals. The assumed behaviour of the individuals comprising the government stands in stark contrast with the way in which these same individuals are viewed in their private dealings. There, they are modelled as self-interested agents. Over the last three decades or so, public choice economists have urged the profession to adopt a more consistent view of economic man in their models. They argue that the same model of man ought to be used when carrying out a comparison of the market and the government. Failure to do so leads to the problem of comparing apples with oranges.
As soon as one adopts the view of man in government as being self-interested and imperfectly informed, then the case for government intervention may founder. For example, in the farmer /grazier case discussed above (in Section 3.2.1), regulatory intervention by the government led to an improvement in resource allocation. This was the case because the government was implicitly assumed to know the appropriate herd size. This requires that the government be fully aware of the cost structure of the farmer and the grazier. In the absence of such very detailed knowledge, government intervention may in fact worsen the allocation of resources. For example, the tax may be set at an inappropriate level or restrictions on herd sizes may be incorrect. To make the point clear, suppose the government decrees that graziers shall not run any more than 9 head of cattle. In that case, as is indicated in Table 3.1, the profits of the grazier are reduced by $18, while the crop losses of the farmer are reduced by only $15. The collectivity has given up $18 in order to save $15, and is actually worse off as a result of the governmental decree. Even if the government had perfect information, it still may not have the incentive to provide the socially optimal policy. The reasons for this will be discussed at length below.
The general point to be drawn from this is that the case for government intervention requires a comparison of relevant alternatives. One must not compare an actual situation to some theoretically ideal state, which would only be attainable by a omniscient, benevolent government. Rather, the comparison should be between the original situation and whatever an imperfect government makes of it.
ENDNOTES
10. See Brooks and Heijdra (1990) for a further discussion of the economic consequences of common property resources.
11. We are assuming away so-called incentive problems, that is, individuals do not attempt to misrepresent their income and thereby avoid taxes. The second thing we are assuming is that there is a positive relationship between income and utility for both agents. Thirdly, we assume away envy: the well-being of one agent is not directly dependent on the well-being of the other.
12. The assumption is made that once the right has been assigned to the grazier then there will be no further transaction costs. This is an heroic assumption. Suppose that the property right is indeed allocated to the grazier. The farmer may nevertheless invest some time and resources in determining whether or not the grazier would be willing to reduce his herd size. For after all, the information contained in the table is not known in its entirety by either individual and the farmer may have to spend some resources to find out that there are no gains to be had from trade with the grazier. The transaction costs associated with this unfruitful search would reduce the size of the net benefits from the two farming operations. To the extent that these costs are an unavoidable part of the process of exchange, there is no problem of waste here. There is no alternative institutional form that could achieve the outcome of finding out whether or not trade is possible at lower cost.
13. The discussion here follows that of Roland McKean (1958, pages 137-8).
14. These figures are in dollars of the year indicated at the top of each column. As a result, they are compatible across columns but not across rows. The present value calculated at the beginning of period t, PVt, is defined as follows.
where β=1/(1+r) is the discount factor, and Pt+τ is the earning stream in period t+τ. In the example, the earning stream is described by Pt+τ=150+5τ (τ =0, 1, ...). Under these conditions, PVt can be calculated as PVt = 150/(1-β)+5β/(1-β)2. From this, we can recursively calculate future Present values, PVt+1=PVt+5/(1-β).
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