EXTERNALITY

Market Failures

Three conditions under which free or incomplete markets fails to achieve efficient
resource use.

1. The market is not purely competitive

2. The resource is a common property or open access resource
3. There are externalities
Each one of these conditions constitute a market failure. Prices generated in the market do
not provide firms and households with the incentives needed to achieve socially efficient
resource use.

Market failure due to resource is not purely competitive

Suppose there is one buyer of resource (monopsony). Demand curve for the commodity using
the resource (D), marginal cost of production of purely competitive industry (MC c) and
monopsonist (MCm)

Price
MCM

MC
PM

PC

D
QM QC Quantity
Under perfect competition, individual firms cannot influence price paid for the resource. Each
firm can purchase as many units of resource at market price. Marginal cost under pure
competition (MCc) determined by adding Marginal Cost curves of all firms in industry.

In monopsony additional units of resource purchased by paying higher price as there is

one buyer of resource. The higher price applies to all units purchased. Therefore MC m>MCc,
which causes equilibrium price higher Pm>Pc and equilibrium quantity to be lower (Qm<Qc)
with monopsony than pure competition. Resource use is not efficient which reduces economic
welfare with monopsony.

Externalities

An externality exists when the activities of acting party influence the welfare of an
affected party and the acting party does not consider how its activities affect welfare of the
affected party. This takes place between firms, between households and between households and
firms. If the acting party engages in an activity for benefiting or harming the affected party, then
it is not an externality.

If externality present, welfare of affected party is influenced not only by its activities, but
also by activities of acting party. If cone family plays loudspeaker in night without concern how
it affect neighbors and music prevents neighbors from sleeping, then it is as externality.

Externality is relevant, affected party wants acting party to change activity that causes
externality

Not relevant, affected party does not care when acting party changes the activity causing
externality.

Pareto Relevant Externality

Activity causing relevant externality changed so that welfare of affected party increased
without decreasing welfare of acting party. E.g. Lowering volume of music does not reduce
welfare of cone family but neighbors would better off.
Types of externalities

2 types pecuniary externality and technological externality and latter adversely affects
economic efficiency.

Pecuniary when company developed software package that reduces time for electronic
communication. Other firms doing business with the company get benefit from time savings but
do not bear cost of developing software. This externality changes only relative prices and
financial condition faced by affected parties, it does not result inefficient use of resource.

Technological affects level of production or satisfaction achieved by affected party, which

results inefficient resource use. E.g. Core family playing loudspeaker.

2 types External economies (increases welfare of affected party )and external diseconomies
(decreases welfare of affected party).

Activity generating externality external to affected party-external. Because of negative welfare

effects, external diseconomies are of great concern than external economies.

Externalities classified according to whether there is conflict between acting and affected
parties and whether they cause inefficient resource use which is given in Table.

Classification of Externalities

Types of Externality External economy External diseconomy

Technological No conflict Conflict

In efficiency Inefficiency

Pecuniary No conflict No conflict

No inefficiency No inefficiency
Examples of externalities

Consider an external diseconomy in which acting parties are farmers located in

agricultural watershed and affected party is a hydroelectric power company located downriver
from watershed. Crop production by farmers causes erosion, which generates sediment which
reduces water storage capacity of reservoir and decreases electrical generating capacity.
Periodically the company has to dredge or remove sediment from reservoir. The cost of dredging
is offsite damage from soil erosion. An external diseconomy is created because farmers ignore
this damage. MC of production is less than Marginal Social Cost (MSC) and the difference
between two is marginal sediment damage incurred by Power Company. Divergence between
MSC and MC (MSC-MC) causes privately efficient crop production exceed socially efficient
crop production (Qt>Qs). Hence level of crop production is too high in presence of external
diseconomy and prices are lower (Ps>Pt).

Price MSC

MC
Ps

Pt

D
Qs Qt Quantity

Consider an external economy between a farm operated by Mr. Jones (acting party) and
a ranch operated by Mr. Davis (affected party). Mr. Jones sprays his corn field with a herbicide
to reduce yield losses from weed infestation. Mr. Davis grazes cattle on a pasture. Herbicide
reduces weeds in both their fields. Mr. Davis benefits from improved pasture without any cost.
 MSB

MBj

MB1 + MB2

MB2

P=MRCj

MBd
MB1

Q Qt Qs Quantity

Marginal resource cost and marginal private benefit of herbicide use for Jones is MRCj and
MBj.

MRCj is increase in herbicide application cost from using another unit of herbicide. MRCj =
price or herbicide.

MBj is increase in corn production from using another unit of herbicide. MBj decreases as
herbicide use increases.

Efficient herbicide for Mr. Jones is Qt where P=MBj.

Mr. Jones selects weed control based on weeds in his field, so weed control is not
effective in Davis field. MBd < MBj.

MSB is summing MBj and MBd which is MSB=MB1 + MB2. Socially efficient herbicide
use is at Qs where p=MSB. With external economy, private efficient use of resource use is less
than socially efficient case (Qt < Qs).
 External economy has opposite effect of inefficiency caused by external diseconomy.
External diseconomy results in overproduction of crops whereas external economy results
in underutilization of herbicide use from social viewpoint.

Externalities occur between households. Road project between city of Argone and
suburban Belluve. Residents of Balluve use road to commute jobs in Argone. For catlin town
located in between Agrone and Belluve, project results road traffic and traffic congestion. The
proposed road project improves welfare of Belluve residents and decreases welfare for catlin
residents.

External economy between households exists when landscape improvements by Ryan

family increases aesthetic value experienced by neighbor and / or value of neighbor’s property.
Externalities between households and firm when aerial application of pesticides by farmers
posing health risk to households.

PROPERTY RIGHTS

Property rights are efficient if they satisfy four basic properties

Ownership

Specificity

Transferability

Enforceability

Ownership determines legal right to use resource. When resources are privately owned,
ownership secured by payment in an amount that is mutually agreeable to buyer and seller.

Exclusive ownership or restrictive ownership requires costs and benefits associated with
ownership and use of resource borne by owner. It allows resource owner to let another party use
the resource e.g. absentee landowner.
Res nullius, property belongs to no one.

Res communis, common or communal property owned or managed by a group of kindred

individuals such as tribe or clan.

Specificity refers to bundle of rights that apply to a particular property. It determines what can
and cannot be done with the resource. E.g. cattle owned by a rancher grazes neighboring land,
the property right is violated. Rancher required keeping the cattle off by fencing. Resource
conflicts can be resolved when the rights of rancher and neighbor completely specified.

Transferable which allows resources to be allocated to their highest valued use. For e.g., to
reduce erosion rates, U.S. government purchased cropping rights on highly credible land for 10
years and landowners got annual rental payment. CRP was possible since landowners transferred
cropping rights to government. Transferability makes possible the leasing of private land.

Ownership, specificity and transferability of property rights are of limited value without
enforceability.

Enforceability requires that property rights enforceable and enforced when there is a violation.
E.g. Eutrophication of lake occurs when phosphorus applied to surrounding land washes into
lake. Enforceability requires water quality monitored for violation of standard and sources
contributing to violation identified. Enforceability requires that appropriate action taken when
violation occurs like offenders required reducing pollution loading to lake or paying a fine.

Unintentional violation occurs when pollution of lake is due to rain on the day following
application of manure.

Intentional violation occurs when industry releases amount of phosphorus to lake that exceeds
the standard.
PROPERTY RIGHTS

Property rights refer to a bundle of entitlements defining the owner’s rights, privileges
and limitations for use of the resource. By examining such entitlements, we understand how
environmental problems arise from government and market allocations. The property rights are
vested with individuals in a capitalist economy or with State in a centrally planned socialist
economy.

Efficient Property Rights Structures has four main characteristics

1. Universality : All resources are privately owned and all entitlements are completely
specified
2. Exclusivity: All benefits and costs accrued as a result of owning and using the resources
should accrue only to the owner either directly or indirectly by sale to others.
3. Transferability : All property rights should be transferable from one to another in a
voluntary exchange
4. Enforceability: Property rights should be secure from involuntary seizure or
encroachment by others.
An owner of a resource with well-defined property right has a powerful incentive to use that
resource efficiently because a decline in value of that resource represents a personal loss. For
e.g., a farmer fertilizes and irrigates his land because of increased production he gets from it.
When well-defined property rights are exchanged, it facilitates efficiency.
COMMON PROPERTY

Common Property Resources (CPR) or res communes are those properties owned in
common by identifiable group of people. They are widely prevalent in India especially in semi-
arid and arid regions, hill regions, forest and tribal regions. In semi-arid and arid regions, the area
under CPRs is very low but closely integrated with well-defined institutional setup. In hill
regions, the use of CPR is high but ownership rights are defined not clearly while in forest tribal
regions, the use of CPR is variable. The majority of area under CPR comes under open forests,
surface ground water and fisheries. The CPRs occupy a quite significant area under non-forest
lands with 38 per cent, ground water with 44 per cent, fresh water ponds and tank fisheries with
80 per cent.

In common property resources, the transaction cost of continual negotiation prevalent

among private owners is absent and also the enforcement cost is very minimal. In addition, it
serves as an appropriate insurance against individual failure. CPRs’ have some significant
characteristics, which distinguish from Private Property Resources (PPRs) or State Property
Resources (SPRs) or Open Access Resources (OPRs). Firstly, improperly defined individual
private property rights, which lead, to the usage of the resource characterize it by more number
of individuals as against the capacity of the resource system to sustain. Secondly, the CPRs are
characterized by joint use among the members of the community. Whenever, resources are used
jointly, members try to maximize their marginal private benefits and minimize their marginal
private cost as against socially optimum benefits or costs.

Mclean (1987) had given three such private profitable actions namely:

1. Perceived private costs to individuals for encouraging internal cooperation exceed private
benefits of cooperating.
2. Individuals feel that their own contribution to a collective goal is miniscule and would be
unknown if they do not contribute at all.
3. Individuals are also not sure that other members of the groups shall be making their
contributions; therefore they have a feeling that their lone contribution to the effort would
be insufficient to produce the desired effect.
 This situation arises specifically under CPRs whenever, there is failure on part of institutional
mechanisms to coordinate the activities of users of CPRs to attain an optimal rate of production
or consumption for the whole community. Joint use rights in management of CPRs, however,
contribute to the social and economic stability of rural communities. In spite of these positive
features, the CPRs are overexploited due to commercialization, rapid population growth, rapid
technological change and lack of community control over resource due to breakdown of rules
and regulations.

CPRs are also characterized by the presence of externalities- the action of one
individual causing appreciable damage or benefits to other individual, who were not fully
consenting parties in reaching the decisions. This problem of externalities creates a lack of
incentives on the part of users to invest money in conservation of CPRs, which ultimately lead to
resource degradation. Rivers and lakes are polluted by discharge of toxic effluents and sewage.
The wastelands are degraded due to water erosion. In arid and semi-arid regions, ground water
depletion occurs at faster rate than natural recharge leading to increased pumping cost.

In CPRs, the potential users not belonging to the group are excluded and the users are
bound by rules, regulations and conventions, which are not prevalent in open, access regime.
They are also termed as everyone’s cradle but nobody’s baby because CPRs subject to
individual use but not individual possession. CPRs are like mixed collective good since as like
pure collective goods, used in common by all eligible members of the group with free riders
difficult to exclude or expensive and like non-collective good, use is subtractible or competitive.

CPR problem also termed as ‘no technical solutions’ problem since it cannot be resolved
by introducing only technical changes. It required proper understanding of human values,
attributes, behavior and institutional foundation of the system, which would be better known by
reviewing different models of management regimes

OLSON’S THEORY OF COLLECTIVE ACTION

Mancur Olson (1971) argued that unless there is coercion or some special device to
make individuals to act in common interest, rational, self interested individuals will not act
to achieve their common or group interest. Each firm of CPR user expands its output till the
market price falls and equals its marginal cost until industry’s excess profit is eliminated. The
firms still have the common interest in a higher price for the industry’s product. Each firm
behave this way as rational because if it were to restrict its own output, anticipating a fall in
market price resulting from increase in industry output, it would loose more than ever for its
price would fall quite as much and have much smaller output.

CPRs are like mixed collective goods and which once produced, available to all the
members of organization. The individual members of CPRs, usually large, are a small entity to
have significant impact on organization by contributing or not contributing to its maintenance,
but share its benefits even he has not contrived or in other words, free riding is possible in all
organizations.

In general, the larger the group, the less noticeable the actions of individual members,
higher the transaction costs of bringing them together and higher the tendency among the
members to free ride. That is why large groups frequently fail to provide collective good for their
members. On the other hand, in small groups, each of the members or at least some of them will
find his personal gain from having the collective good exceeds the total cost of providing the
collective good.

Value or benefit to the group from collective good by

Vg = Sg. T where

Sg = group size

T = Level of output

Cost of providing the good C = f (T)

Benefit to the i th member of group = Vi

Fraction of group benefit gained by i th individual Fi = Vi/Vg

Net benefit to the i the individual Ai

= Benefit – cost of individual

 = Fi Sg. T – C

= Vi – C

To maximize A, dai/dt = dFi Sg. T/dt-dc/dt = dvi/dt – dc/dt =0

Also, dvi = Fi Vg

------- ------------

dT dT

Fi (dVg / dT) = dc / Dt

For an individual, optimal provision of collective good would be that at marginal private
benefit equals the marginal cost. For group, it is Fi (dVg/dt) = dc/dT. Therefore a rational
individual member of a group will not provide collective good in quantities optimal for the group
as a whole.

Olson defines three groups namely small or privileged group, intermediate or

oligopoly group and very large or latent group. For the privileged group, gains from
providing collective good (Vi) exceeds own private cost (C) i.e., Vi>C. Here, one member could
profitably provide the collective good entirely at his own private cost and there is systematic
tendency for the exploitation of the great by the small. In latent group, for which Vi<C for all i,
suffer without the collective good because no individual member could supply the CPR good
privately and that is why CPR is used by large group are often over-exploited and degraded. In
intermediate group, two individuals must act to provide collective good but require some
group coordination or organization for provision.

Olson did not specify the number of individuals making the small group but should
be small enough so that individual actions of any one or more members are noticeable to any
other individual in-group. If a group using CPR is very large and heterogeneous, it should be
divided into a number of small and homogeneous subgroups. Each subgroup randomly assigned
a portion of CPR proportionate to the group size. If there are marked variations in quality of
CPR, the assignments may be rotated every year provided, if CPR is divisible and if some
arrangement exists for dividing and apportioning the CPR into subgroups. In CPR management,
the role of political entrepreneur is to provide assurance to CPR users that expected benefits from
collective management could actually accrue to them and distributed equitably among them.

OPEN ACCESS REGIME

Defined as nobody’s property or property for which property rights are not defined.
Access to such property is free and unrestricted and has no rules and regulations governing its
use. It is non-exclusive property since no one excluded from its use and it is everyone’s property.
Problem of common property stem form inappropriate system governing joint use rights.
Problem of open access is due to free and unrestricted access or resulting from lack of ownership
of resource by person. Therefore Common dictum that ‘Everybody’s property is nobody’s
property’ (Gardon, 1954) and hence open access is likely to be abused, misused and
overexploited more than private or common property.

As population of resource uses increases, then demand for resource increases and finally
result in social conventions and institutions regulating use of CPR weaken causing CPR to
become open access (Bromley 1991). If resource base is plentiful compared with demand, open
access becomes ideal because it does not involve any transaction cost. Sunlight and oxygen are
examples of plentiful open access resources. As resource become scarce, its value increases,
create more demand and result in degradation. Problem of open access is the lack of secure
property rights and limited availability of resource creates uncertainty about access to and
availability of resource use. Competitive equilibrium use of open access resource is socially
inefficient as private marginal cost of harvesting resource say fish is less than social marginal
cost of harvesting

Common property and Open Access Resources

Common property is resources owned in common and managed for common

purpose. Owners have exclusive rights to property but cannot exclude one another from
using it.
 If frequency of use not restricted, as in City Park, resources overexploited which result in
Garrett Hardin’s tragedy of commons. If frequency of use by owners restricted, as with tribal
grazing land in African countries, overexploitation is avoided.

OAR are not owned by anyone. Not practical to exclude others from using them and no
incentive for individual to limit his or her use of resource. E.g. ocean fisheries.

Value per low MNPB

MD

Qn QS Qt
Stocking Rate

Overexploitation of CPR is illustrated for cattle grazing. Efficient stocking rate is

demonstrated in the figure. Each rancher has complete freedom to select his own stocking rate.
Marginal Net private benefit (MNPB) is difference P-MC of production for cattle. Profit for each
rancher is minimized by selecting a stocking rate Q t where MNPB=0. At Qt price of cattle equals
marginal cost of production.

When stocking rate exceeded namely Qh, reduces forage for each cow and overgrazing
occurs. The marginal damage (MD) from over grazing equals loss in income from grazing an
additional cow when stocking rate eceeds Qh. MD is a linear function of stocking rate when rate
exceeds Qh.

When each range independently selects profit maximizing stocking rate namely Q t,
damages to rangeland is maximum. This calls for joint management and ranchers agree to
stocking rate that maximizes net social benefit = total profit-damages from overgrazing=area
between MNPB and MD curve =QS stocking rate.

QS maximize net social benefit and it is socially efficient stocking rate. Q s is less than privately
efficient stocking rate Qt.

One way to restrict CPR or OAR is to ration the resource. In case of offshore Oil,
Government offers bid to companies for specific tracts of offshore land. Company gets exclusive
development rights and leasing ensures efficient property rights.

In case of OAR, over exploitation occurs. For e.g. harvesting of whales since it is
valuable and no restriction is there, harvesting exceeds regeneration. Another example is air
pollution. Urbanization and industrial development increased air pollution which controlled by
restricting emissions or tending emissions. Tradable emission permits achieves target level of
emissions at least cost.

Alternative resource management systems

Privatization, public management or collective management used to achieve goals of

natural resource management. In practice all three coexist in most situations.

a. Privatization

This creates property rights in open access or common property and enforces them. It is
accomplished by enacting laws, issuing government decrees and resolution, and signing
voluntary contracts rights conferred on individuals, group, firm, co-operative society or
voluntary agency. Appropriate management is required when following conditions are met

 As economic development proceeds, open access and CPR resources and products
become valuable and scarce, pressure for privatization develop endogenously.
 Assignees of property rights are mostly poor ad preferably organized into group.
Membership is open to all and equity criterion is satisfied.
Provisions for equitable sharing are incorporated in bylaws of association. Government is willing
to help with funds, technical information, guidance and training. Free riders are excluded.

b. Public management

Government owns and directly manages the resources through its departments or
agencies. Nationalization is done to serve interests of people/ raise investment fund / have longer
planning horizon and hence lower discount rate than individuals.

Experience of nationalization of OAR is not successful but nationalization of CPR is

appropriate under following conditions

1. Resource users are not able to organize themselves to regulate use of open access of a
CPR, then resource is overexploited, degraded and damage becomes irreversible.
2. A resource of strategic importance to nation and scarce resource.
3. Investment and technology is required for restoration, conservation and appropriation of
degraded resource beyond the reach of users.
4. To arrest private monopoly lead to socially undesirable consequences as significant
economics of scale in appropriating the resources. Nationalization is resorted as short –
term measure and should have people centered approach.

c. Collective management

Management is by local people who use resource conventionally or own it in common.

Collective management of OAR and CPR is suggested. Collective management succeeds if it
mimics private property resource management by excluding free riders and minimizing
transaction costs. In addition, following conditions are congenial for its success.

a. The community of users of OAR and CPR are small, well – defined, homogeneous, self –
conscious, self-governing and organized into association headed by a capable leader.
b. Access to and use the resource is regulated by set of rules compatible with technical and
physical characteristics of resource and local setting. Rules are mutually accepted,
enforced and monitored by CPR users themselves.
c. Rules have legal backup, easy to understand and enforce.
d. A system of sanctions against violation of rules and free riding or shirking.
e. Resource users have high stakes in resource and immediate threat to well being of
resource degraded or depleted.
f. Government is willing and able to help resource users with needed funds, technical
information, training and provision of infrastructure including marketing and processing
facilities.
g. Expected private benefit to each individual exceeds expected private cost and supported
by local leader.
 TRANSACTION COSTS

The cost of achieving efficient property rights is transaction cost. It is small when few
individuals involved and conflict is minor. It is high when many parties involved.

The high initial cost of establishing market based capitalistic system in former Soviet
Union states is front end transaction cost. Perennial transaction cost include cost of deciding
which rights determined by market versus non market forces, resoling conflicts in resource use
and enforcing property rights.

1. Market versus non-market forces

Access to health care in U.S is determined by market forces. Who desire and afford can
purchase it. Another alternative is public sponsored health care which is national health care or
socialized medicine.

2. Resolving resource conflict is a major perennial transaction cost.

- Competition between agricultural energy and urban water uses

- Use of public lands for grazing, mining, timber harvesting, water supplies, recreation and
endangered species

- Enforcement of prime agricultural lands by urban development

- Pollution of air, soil and water by agricultural urban and industrial activities

-Globally, resource conflicts caused by global warring, deforestation, Ozone depletion and loss
of biological diversity.

3. Enforcement of property rights entails major costs, conflicts exists at all political levels of
local, state, national, regional and international and increasing due to development, population
and environmental pressures
PUBLIC GOODS has two characteristics

1. Property rights to the good are not exclusive

2. Use of the good by one person does not diminish the benefits that the good provides to
other persons.
Example national defense, interstate highways, public education and national parks.

National parks

Marginal cost of wildlife viewing is low and so charge low fee. High fee excludes some
users. So private users are not interested in managing the park. It is a public good and need to be
managed by public management. But the fee is low. Access fee covers some administrative cost
and bulk of operating cost comes from general tax revenue.

PUBLIC GOODS

Olson based his analysis on Paul Samuelson’s theory of public goods. Samuelson (1954)
noted that some goods, once they are made available to one person, could be consumed by others
also with no additional marginal cost. This condition is commonly called jointness of supply or
non-rivalries of consumption, because your consumption of the good does not affect mine, as
your eating a lovely dinner would block my eating it. Therefore, in standard price theory, in
which price tends to equate to marginal cost, such goods should have a zero price. But if they
are priced at zero, they will generally not be provided. In essence, price theory commends free
riding on the provision of such goods. This might sound like merely a cute logical problem; but
standard examples include radio broadcasts, national defense, and clean air. If any of these is
provided for anyone, they are de facto provided for everyone in the relevant area or group.

There is a second feature of Samuelson’s public goods that would make them
problematic in practice; the impossibility of exclusion. Once supplied at all, it is supposedly
impossible to exclude anyone from the consumption of a public good. It is often noted that this
feature is analytically interesting but empirically often beside the point. States often forcibly
exclude people from enjoying such public goods as radio broadcasts. Others can be provided
through the use of various devices that enable providers to charge the beneficiaries and to
exclude those who do not pay. For example, by advertising that imposes a cost on television
viewers or the use of cable rather than broadcasting over the air to provide television
programming at a substantial price. Exclusion is merely a problem of technology, not of logic.
With present technology, however, it may be too expensive to exclude many people and we may
therefore want the state to provide many goods so that we can avoid the costs of exclusion.
There are some compelling cases of goods that are both joint in supply and non-
excludable. National defense that protects cities against attack from abroad, for example, is for
all practical purposes a good with both these features. But the full logic of public goods is of
little practical interest for many important contexts. Indeed, what are often practically and
politically interesting are goods that are in fact provided collectively, independently of whether
they have either of the defining features of public goods. We can even provide purely private
consumption through collective choice. For example, most welfare programs transfer ordinary
private consumption goods or resources for obtaining these. Although technically these are not
public goods in Samuelson’s sense, we can refer to them as collective goods and we can treat
provision of them as essentially problems of collective action.

Olson notes that very many politically provided goods, such as highways and public
safety, roughly have the qualities of Samuelson’s public goods and therefore face the problem of
free riding that undercuts supply of the goods. Note that the supply of such goods by the state
overcomes the free rider problem because voters can vote on whether everyone is required to pay
toward the provisions, as in the care of national defense. If I am voting whether the good is to be
provided, I cannot free ride and I need not worry that anyone else can either. We can all vote our
overall preferences between supply of the relevant individual cost versus no supply and no cost
of provision, so that democratic choice turns our problem into a simple coordination if we are all
in agreement that a relevant goods should be collectively provided.

From the analysis of the de facto logic of collective action that would block the
spontaneous provision of many fundamentally important classes of collective goods we can go
on to argue for what is now often called the public – goods theory of the state. The public –
goods account gives us a clear normative justification of the state in Welfarist terms: The state
resolves many centrally important and potentially pervasive free rider problems. It does not give
us an explanatory account of the origins of the state, although it could arguably contribute to the
explanation of the maintenance of a state once it exists. It might do so through support for the
state’s collective provisions and, therefore, support for the state. Unfortunately, as libertarians
are quick to note, giving the state power to resolve certain free rider problems also gives it the
power to do many other things that could not be justified with similar normative arguments.

CLUB GOODS

Club goods or States’ legal system is a good that only Club members or citizens of state
supposed to enjoy. It is spill over to members who are not formally club members Rule of law
have positive externality for citizens in neighboring states. State is the most important supplier of
formal institutions. Enforce public goods like defense and justice and expect loyalty, sympathy,
gratitude, votes or even material benefits. Informal institutions are each individual convinced
with the righteousness to comply and punish possible defectors. It requires spending time or
effort and one in order, it become a public good.

The Club goods and property rights

Douglas C. North (1981) linked theory of state with theory of property rights. State gives
police and justice. State acts as discriminating monopolist, separate each group of constituents,
devise property rights for each with aim of revenue maximization It has potential rivals of other
states and individuals in existing political – economic provides. It provides fundamental rules of
competition and cooperation including structure of property rights for revenue maximization.
With in property rights structure, state reduces transaction costs so that output is maximized
which in turn maximize tax revenue accruing to state.

On the other hand, there is persistent tension between structure of property rights
maximizing state’s revenue and efficient system of reducing transaction cost promoting
economic growth. This tension is a root cause for failure of societies to experience sustained
economic growth. Fundamental organizational constraint is from constitutional rules of 1.
Specifying a pattern of wealth and income distribution. 2. Specifying a system of protection in a
universe of competing states 3. Laying framework for a system of operating rules to reduce
transaction costs in economic sector.

State creates infrastructure to specify and enforce body of property rights. State set rules
to control behavior of agents and the rules constraint it imperfectly. Efficient property rights
produce higher income to state. But not increase tax revenue to state because cost of monitoring,
metering and collection of taxes form large number of continents also increase. If may be easy
and cheap to collect taxes from wealthy monopolists than hundreds of free traders. So state
allows inefficient property rights to continuance to maximize its revenue. Once state specified set
or property rights, it attempt to reduce transaction cost by providing public goods and services
like currency, public utilities like road, judicial system to settle differences and police and
military to maintain compliance to rules. State with inefficient property rights survives because
of free rider problem. Cost of maintenance of existing order is inversely related to perceived
legitimacy of existing system. Perceived legitimacy induces people to become free –riders. So
State invest resources to persuade people to believe its legitimacy.

State faces competition form citizens in many economic activities like postal department
and state transport. As state’s protection is not available, transaction cost for potential rivals is
high which restrict scope of their operation. The more powerful the potential rivals are, greater
the discretionary behavior of agents of state and lesser revenue is obtained by state. Weaker the
state is, greater is the perpetuation of inefficient property rights and the lesser will be tax income
accruing to the state. Agents of state like bureaucracy and police combine with specific groups to
slacken proper monitoring and entering. Political and economic organization has common set of
basic characteristics like

1. Establishment of set of constraints on behavior in form of rules and regulations.

2. Set of procedures designed to detect deviation from and enforce compliance with rules
and regulations.