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Economic analysis of ground lease-based land use system

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Economic analysis of ground lease-based land use system

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ECONOMIC ANALYSIS OF GROUND LEASE BASED LAND USE SYSTEM
Copyright 1999
by
Fena Dena
A Thesis Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
MASTER OF ARTS
(ECONOMICS)
August 1999
Feng Deng
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U N IV E R S ITY O F S O U T H E R N C A LIF O R N IA
THE GRADUATE SCHOOL
UNIVERSITY RARK
LOS ANGELES. CALIFORNIA 1 0 0 0 7
This thesis, written by
Feng Deng
under the direction of A J L ?.— Thesis Committee,
and approved by all its members, has been pre
sented to and accepted by the Dean of The
Graduate School, in partial fulfillment of the
requirements for the degree of
MASTER OF ARTS
D a te „X ls& „.2 JiL,.. 1 3 9 3. __
THESIS COMMITTEE
u . a.
. . I ? .
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ACKNOWLEDGEMENTS
I would like to express my gratitude towards Professor Peter Gordon for his guidance
and support during the course o f this thesis. The basic ideas in this thesis were originated in
a directed study 1 took under his guidance in the Spring 1998. His comments and questions
on my thoughts had pushed me to think about many important points that are crucial to this
thesis. I especially thank him for his scholarship and encouragement that has helped me
throughout the whole process. 1 extend my thanks to Professor Harry- Richardson for his
valuable comments on the thesis and also to Professor Jeffery Nugent for being on my
committee.
I am also grateful to Professor Rena Sivitanidou for her valuable comments and
suggestions on various versions of the thesis. Starting from my first day on this land, her
continuous support has been behind my progress.
A special thanks to my wife Youqin for her understanding, support and
encouragement during the course o f this thesis.
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ii
ABSTRACT
The recent decades have experienced the development o f ground lease based land use
systems in modem urban society, especially in commercial real estate. This thesis tries to
study its efficiency properties and limits. Focusing on territorial collective goods (Foldvary
1994). I argue that "market failure" does not necessarily lead to government. Because
landowners have only limited ex post mobility, ground lease system is an efficient
institutional response to the fundamental transformation o f the relationship between
landowner and the provider o f collective goods. However, bundled consumption of private
good— land and collective goods requires a tradeoff between the efficient forms of property
rights for the two kinds o f good. C1D preserves the merits o f sole ownership o f private good
while efficiently providing collective goods through a hybrid governance structure. The
different characteristics o f commercial and residential real estate determine the dominance of
ground lease systems and CIDs respectively.
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iii
TABLE OF CONTENTS
ACKNOWLEDGEMENTS ii
ABSTRACT iii
CHAPTER 1
INTRODUCTION 1
CHAPTER 2
MARKET FAILURE AND TERRITORIAL COLLECTIVE GOODS 7
Traditional Arguments for Market Failure 8
Territorial Collective Goods 10
The Real Reason for “ Market Failure” 13
Bundled Consumption vs. Provision Bundling 16
CHAPTER 3
GOVERNMENT FAILURE AND THE TIEBOUT MODEL 22
Vote-by-property versus Vote-by-head 22
Exit and Voice 25
Failure of Tiebout Model 27
CHAPTER 4
THE FUNDAMENTAL TRANSFORMATION AND THE EFFICIENCY 30
OF GROUND LEASE SYSTEM
Transaction Cost Economics and the New Institutional Economics 30
The Fundamental Transformation 34
Efficiency Properties o f the Ground Lease System 38
The Institutional ‘Spectrum’ 42
CHAPTER 5
GROUND LEASE VERSUS CID 46
Efficiency Properties o f CID: The Transaction Cost Perspective 47
Property Rights Economics 49
Measurement Cost, Collective Goods, and Bundled Consumption 51
Commercial versus Residential Real Estate 55
Ex Ante Ownership versus Ex Post Governance 59
CHAPTER 6
LEASING AND MONOPOLY 62
Theories on Durability, Monopoly and Leasing 62
Ground Lease System and Monopoly 64
CHAPTER 7
CONCLUSION 67
BIBLIOGRAPHY 72
iv
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CHAPTER 1
INTRODUCTION
Ground lease, as a basic form o f property rights, has been in existence for a long time
in human history. Far back in the feudal societies, ground lease was the economic foundation
o f the social hierarchies at that time. With the rise o f private economy and the simultaneous
weakening o f the nobles, the tax system has largely replaced the ground lease system. But is
that the end o f the story? The answer is no.
It was exactly the problems with the tax system that motivated Henry George to
advocate a single tax to finance urban public services, which is basically equal to the ground
rent. Although his concrete proposals may not be a popular one in ‘social engineering', its
rationale that public services are capitalized into land value has manifested itself through the
spontaneous evolution in the real world. In the contemporary world, there are many land use
systems that are based on the ground lease, at both the macro and micro levels.1 Most ground
lease systems at the macro level are either due to historic reasons, such as Hong Kong and
Hawaii, or because of particular institutional circumstances, such as China." On the other
hand, in the recent decades a rebound of the ground lease based land use system within
modem metropolitan areas has greatly changed the urban landscape at the micro level. The
most visible examples are large shopping centers, industrial parks, entertainment centers, etc.
It is obvious that in different periods o f the history the ground lease system has different
1 Here macro level refers to the city or state, while the micro level refers to within the city or the metropolitan
area. This follows standard urban economics textbooks (see Dipasquade and Wheaton 1996).
: During its transition to the market economy, China in the early 1990s formally adopted the ground lease of
publicly owned land as the foundation o f land use in its urban areas. Its rural land still belongs to rural
collectives.
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forms because o f particular historic circumstances. But the same merits guarantee its
survival and rebound, albeit, in an era with new technology and new social institutions.
In a ground lease based land use system, as in a common lease arrangement, land
users lease the land from the owner for a certain period o f time. What is different is that the
owner is responsible for providing various territorial services such as security, street
cleaning, water and power, etc/ Commercial leases o f shopping centers and industrial parks
are typical examples o f this system. Within this system the landowner is the provider of
these collective services, although not necessarily the producer of those goods. For example,
the landowner decides the form and level of security arrangement and then from a pool of
competitors selects a security company that provides the security guards or security
equipment. The communities in a ground lease based land use system (or, 'entrecoms' in
MacCallum's terminology) are formed in the market and function within the market
mechanism. They are based on private lease contracts and are totally voluntary. The basic
rationale is the same as what Henry George advocated more than 150 years ago. except that
he argued for a single tax and the public ownership o f land. It seems that George found the
right principle but limited himself to only improving the tax system.
George's idea has inspired many theorists. Recent elaboration of George's analysis
(by MacCallum, 1997, and others) argue for the economic efficiency properties o f leasehold
systems. MacCallum, for example, suggests that the hotel and the shopping mall provide a
’ I use the term ‘ground lease based land use system’ instead o f ground lease itself in order to avoid confusion.
In the modem real estate industry ground lease usually refers to a land lease arrangement in which the passive
owner leases the land to the developer. It is the developer who actually constructs buildings and is responsible
for providing various collective services for the property. For my purpose here. I will not distinguish the
landowner from the developer. Another pair o f confusing terms is land user and space user. Although
sometimes land user refers to ground tenant, in this paper I am going to use it interchangeably with space user.
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model for a new type o f residential subdivision o f land, the ’entrecom.' He even predicted
the dominance o f the ground lease based land uses in the future. This line o f thinking is
contrary to most textbook theories in public finance and urban economics, which regard
public institutions like government as the only provider o f public services. In the real world,
past decades have experienced rapid development o f leaseholds in commercial real estate,
such as shopping centers, large entertainment and industrial parks. So. the main research
question is how to analyze the role o f the ground lease based land use system in modem
urban society. What are the efficiency properties of the ground lease system? How can we
explain the growth o f the leasehold systems? Especially. I want to explore the distinction
between the public and the private sector in terms of providing ’public' goods.
However, there may still be other factors that affect property rights in the urban
context and further limit the development of ground lease based land use system. Compared
to commercial real estate, the dominant form in residential real estate is Common Interest
Development (CID). CIDs include virtually all new subdivisions like condominiums and
planned unit developments (PUDs). Residents in such developments enjoy ’common
interests' in public spaces as well as each other's behavior if it is determined to adversely
affect the community. The developer usually sets up a homeowner association or residential
community association (RCA) that ’runs with the land*. Comparing CIDs with the leasehold
systems. MaCallum (1998) raised the question of what makes the difference between
commercial and residential real estate. This question is important in that it shows the limits
o f the ground lease system and potential factors that may influence its development. In this
way it w ill become clear what affects the forms o f property rights in urban areas and what
other efficiency factors must be traded o ff with those o f the ground lease based land use
system.
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Any issue related to land always seems to be very controversial. From a policy
perspective, the biggest concern for a ground lease system is that it might inevitably be
related to the monopoly o f landowner and. therefore, various efficiency and equity issues
might arise. This is the topic that often jumps into people’s mind and appears in the press. Is
the ground lease system inevitably associated with monopoly? What is the relationship
between monopoly and ground lease based land use system? To answer this question, we not
only need to study the theoretical relationships but also look at the history and the
advancement o f society in technology and knowledge.
This thesis tries to analyze the ground lease based land use system from a theoretical
and institutional perspective. My major interest is in the relationship between the ground
lease system and economic efficiency (especially of the 'public sector') in the urban context.
Through the analysis of'public goods' and collective goods, it is shown that the concept of
'public goods' is endogenous to institutions. 'Market failure' does not necessarily lead to a
government— tax system. The vote-bv-head rule in the political process is inefficient in
providing collective goods, while inter-governmental competition cannot fully bring about
the efficiency in the Tiebout Model. I argue that the ground lease system is an efficient
institutional response to the fundamental transformation in the relationship between
landowner and the provider of collective goods. Landowners have only ex ante choice, but
limited ex post mobility. In many cases, the market mechanism is plausible in the provision
of collective goods, and contractual arrangements can increase efficiency.
The fundamental transformation in the relationship between the landowner and the
provider o f collective goods leads to institutions that economize in transaction costs and align
the governance structure with asset specificity. In this sense ground lease based land use
systems increase efficiency by internalizing the problem and bundling the provision o f
private goods and that of collective goods. Across the spectrum o f institutions in the 'public
4
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sector', from Samuelson's pure government model, the Tiebout Hypothesis o f inter
governmental competition,.... to ground lease systems, the last one is the most efficient in
terms of only providing territorial collective goods.
But as a form o f property rights, the ground lease system is not without limits. In
addition to the process of providing collective goods (the exchange process), the
consumption process also impacts the efficient form of property rights and institutions. I
argue that although the ground lease system is the most efficient in providing territorial
collective goods, it could not dominate all the other forms o f property rights in all types of
real estate due to the fact that private goods and collective goods are bundled together.4
Depending on the economic environment and the type of land use. there has to be either a
tradeoff between the efficiency requirements for private goods and that for the collective
goods, or some new institutions to reconcile them. That is the reason for the growth o f CIDs
in residential real estate. So. in spite o f ground lease system's merits in providing collective
goods, there are two offsetting issues: (1) ground lease system involves contracting costs: (2)
people may still want control over the private use of land because it may be too costly and
impossible for them to specify the various uses. Since different people have different
preferences and different purposes in modem urban society, we see many different forms of
property rights instead o f only the ground lease system.
The next two chapters start with theoretical analysis o f public goods and collective
goods and explore the possibility o f bundling the provision o f private goods and that o f
collective goods. Given the inefficiency o f the political process, it is shown that the
■fundamental transformation' in the relationship between the landowner and the provider o f
4 Here I try to distinguish the concept o f bundling the provisions of private good and collective goods from that
o f the bundled consumption o f private good and collective goods. The former is not always and necessarily true,
as often seen in the real world, but the latter is a physical fact.
5
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collective goods greatly weakens the Tiebout Model. The ground lease based land use
system is seen as an efficient institutional response that economizes in transaction costs and
aligns the governance structure and asset specificity. The fourth chapter, from the property
rights perspective, studies the difference between commercial and residential real estate and
analyzes the problems that are created by the bundling of the consumption o f private good
and that of collective goods. In this way the growth of ground leases and CIDs in
commercial and residential real estate respectively can be explained. Finally, the relationship
between ground lease and monopoly is discussed. The last chapter concludes the thesis and
identifies issues that merit further research.
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6
CHAPTER 2
MARKET FAILURE AND TERRITORIAL COLLECTIVE GOODS
The ground lease system derives its merit from the provision of the collective goods,
both historically and in modem society. The manor system of the (Western European) feudal
society is an ancient example of providing collective goods. Peasants (serfs) were allowed to
cultivate the land from the lord and paid rent or personal services to him while the lord
provided them protection and justice (North and Thomas, 1971). Thus the lord was actually
the provider of collective goods in a contractual arrangement with the serfs.3 In the
conventional wisdom of our modem urban societies, public goods have long been regarded as
belonging to the public sector. Foldvary’s work (1994) showed that it is possible for the
market to provide at least some collective goods and hence achieve greater economic
efficiency. The focus of this chapter is on the factors that have important implications on
different forms o f property rights, especially territorial goods and the bundling of goods. The
basic questions are: What is the real reason for market failure? What kind of market are we
talking about ? What is the role of space in the public sector?
3 O f course, not all serfdom can automatically be regarded as a kind of contractual arrangement. In the case of
Western European manor system, the absence o f a centralized political authority helped the rise of a rudimentary
labor market. “The Western European serf, while bom to a contract specifying the kind and extent of his
obligations which he could not change without the lord's permission, was in fact also generally protected from
arbitrary changes in the terms of the contract by the lord as a consequence of the customs of the manor” (North
and Thomas 1971, p. 778).
7
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Traditional Arguments for Market Failure
Economics has traditionally treated public goods as 'pure' public goods that can only
be provided through the public sector— the government. Whenever public goods are
mentioned government is implicitly regarded as the only provider that can fix the ‘free rider'
problem of'm arket failure.' Samuelson's (1954) mathematical formulation o f private versus
public goods is a typical example of this traditional wisdom. For a private good, aggregate
consumption can be parceled out among different individuals according to the relation
where / refers to an individual consumer, n to the total number o f consumers, and j to a good.
For a public good, each individual's consumption does not reduce any other individual's
consumption o f that good.
where / equals I n. Samuelson concluded, "no decentralized pricing system can serve to
determine optimally these levels of collective consumption. Other kinds o f ’voting' or
'signaling' would have to be tried*' (Samuelson 1954. p. 388).
A landmark in modeling the distinction between private versus public goods.
Samuelson's formulation is not without criticism. One important criticism is that not all
goods can be easily categorized in such a black-or-white way. Lancaster (1966. 1971)
proposed the characteristics model o f utility and demand theory. Consumers derive utility
directly from characteristics and only indirectly from the physical goods, constrained by
price, income, and the consumption technology. The Lancastrian characteristics framework
was further integrated with the theory o f public and private choice by Auld and Edent (1990).
n
= 1
8
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In their model, publicness and privateness no longer refer to categories o f physical goods but
characteristics of goods. Richard Auster (1977) also recognized "the publicness of the
characteristics of products".
Summarizing the existing literature, Foldvary provided a refined definition o f a
public good:
A 'public good’ is a characteristic o f an existing phenomenon with a
domain o f impact containing at least two actual persons, such that the
amount o f the characteristic encountered by any individual in the
domain is the entire amount of that characteristic. (Foldvary. 1994. p.
1 2 )
The set of private goods is naturally defined as the complement o f the set of public goods.
From the evolution o f the concept of publicness versus privateness, it is clear that the utility
function is no longer stated directly in terms o f physical goods but rather their
'characteristics', either implicitly or explicitly.6
For theorists who are only interested in the formulation of the utility function, it is
natural for them to stop here. A further deduction along this line w ill lead to one of my main
points, which is important for our understanding o f the distinction o f publicness versus
privateness in urban economics and property rights. On the one hand, what enters the utility
function are the 'characteristics' of the good and obviously all 'characteristics' of any
physical good are physically tied together. On the other hand, most urban economists
address either private or public goods; these are typically not treated in the same model.
Then what happens if in the same physical good (or physical 'phenomenon') there are some
public characteristics and some private characteristics? Certainly we couldn't
6 In my thesis I will not discuss externalities per se. Although public goods and externalities do overlap in
practice, externality is a very ambiguous concept in practice (Cheung. 1970). O f course many arguments in this
paper may also apply to the analysis o f externalities.
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deliver/consume only part o f the characteristics instead of the physical good itself. So the
distinction between public and private is not so easy and clear as people often think.
Foldvary (1994) used 'collective goods' and 'severable goods' instead o f ’public
goods' and 'private goods' in order to eliminate the ambiguity and confusion people usually
have.7 He further divided public goods into four categories according to two features:
potential congestion (with a positive marginal cost in consumption for additional persons into
the domain after passing some threshold) and excludability from the domain (Foldvary 1994.
p. 14).
Congestible Capacious
swimming pool political association Excludable
population growth wildlife s existence Global
This taxonomy focuses on the (spatial) exclusion and the deterioration in the consumption o f
public goods, both o f which ultimately lead to the rising interest in the contractual provision
o f collective goods. By advancing this taxonomy. Foldvary was able to show that due to the
diverse nature o f collective goods the sweeping argument of market failure, such as
Samuelson's formulation, does not necessarily hold. To specify how collective goods can be
provided through a market mechanism, he disaggregated public goods and advanced the
concept o f territorial collective goods.
Territorial Collective Goods
"Human beings are land animals," Foldvary (1994) stated in the first sentence o f the
chapter on territorial collective goods. What he implied is that human beings as social and
economic 'animals’ organize themselves according to different levels of spatial and territorial
7 From now on in my thesis I will use the term ‘collective goods' instead of'public goods' in order to avoid any
confusion.
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areas. Therefore most civic goods are actually territorial collective goods that are provided
within some bounded area. The value o f these territorial collective goods becomes
capitalized into ground rents, and they become accessible only to the residents within the
area. In other words, they are now excludable and there is no longer a free-rider problem.
Even if someone outside the area can occasionally become a free rider, the rent is still paid by
the land user or resident. In this sense, the free rider is no longer free riding because his/her
host has to pay for the cost. Thus no matter how the ground rent is paid and who collects it.
territorial collective goods can allow no free riders as long as the exclusion mechanism exists
for the land and there is enough incentive for people to enforce the rule. Even if the
territorial collective goods are not provided through land rent, i.e.. the provider does not
directly collect the rent, the resident/user still has to pay for the benefit o f those goods. Their
demand for collective goods is revealed in the rent as a market signal. This is the basis o f the
Tiebout-Hamilton model. So. theoretically rent can effectively be the funding source for the
private provision o f territorial collective goods, if they are fully capitalized into land value.
Foldvary's arguments follow the ideas o f Henry George, who advocated a single tax
that is equivalent to ground rent and could be collected by the government for financing all
public services. George's theory implicitly assumes government is (part oO the landowner.
Heath (1957) further envisioned that public services could be financed entirely from ground
rents in a ground lease system. MacCallum (1997) argued that "the business rationale o f land
ownership derives from the fact that public services are supplied to sites rather than to
individuals, and individuals gain access to them through their occupancy of those sites.” He
even predicted the evolution toward proprietary communities that are totally based on
leaseholds. To Foldvary, the choice for the governance of the agents who provide the
collective goods is much wider. It includes proprietary communities (based on leaseholds)
and residential community associations (RCAs), two major types in his book.
II
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These theories about the private provision of territorial collective goods dispel the
cloud that has long plagued studies o f property rights and urban economics. However, these
theories are still limited in several important aspects. First, while emphasizing the possibility
o f private financing o f collective goods, they seldom consider the other side of the story, i.e..
the private-good characteristics o f land and space. In Foldvary's work (1994) he listed both
proprietary communities and residential associations as the basic forms and examples of
consensual governance for private provision o f collective goods. But he fell short of taking
one step further to analyze the reasons for the different forms of the contractual provision o f
collective goods. This is understandable given his focus on establishing the foundation for a
market mechanism in the provision o f public goods. MacCallum (1998). on the other hand,
did raise the question o f why different forms o f institutions exist but he also ignored the role
o f private goods when he searched for an answer. It cannot be denied that the main reason
for people to buy or rent land and space is to occupy the space for private uses such as
residences and businesses.8 This is certainly very important in terms o f people's behavior in
the market and consequent institutional arrangements.
The second limitation is their implicit assumption of the mobility of residents or
space users. They did not pay much attention to the difference between owners and renters.
In MacCallum's analysis (1997) he assumed that users' mobility is not a problem so that
competition between the 'entrecoms' can effectively increase the economic efficiency o f the
leasehold system. Foldvary (1994) did not mention the impact o f users' mobility, but his
clear distinction between public-sector and private-sector governance implied that mobility is
not an issue. Or else there are economic reasons for institutions in the middle area (or gray
a
In some cases it seems that territorial public goods are more important in influencing people's behavior. One
example is that migration between countries can often be linked to the difference in territorial public goods, such
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area which is neither completely 'public' nor completely 'private'). In Boudreaux and
Holcombe's study (1998) on contractual governments they pointed out that the mobility
problem is a limitation to the Tiebout Model. However they did not analyze why this may
lead to contractual government instead o f other forms such as 'entrecoms'. As we will
discuss later in this paper, the issue o f users' mobility has important implications on the
institutions for providing collective goods.
Third, although these theories are basically about institutions, they paid little attention
to history and processes that are fundamental in understanding institutions and institutional
change. The reason might be that their focus is on justifying particular institutions, especially
the issue o f private versus public ones, instead of understanding why those institutions come
into being. Although George saw the critical point of capitalization in land prices, he used
the conventional tool of a tax to justify the public ownership o f land. Foldvary devoted most
o f his work to justifying the possibility o f private communities to provide 'public goods', as
suggested by the title of the book, while he said little o f basis o f the existence o f those
particular communities and why this process is economically efficient. Albeit different in
their directions and policy implications, these theories thus converge in their methodology by
treating institutions more or less as exogenous entities and little consideration is given to the
dynamic evolution o f property rights and institutions.
The Real Reason for “Market Failure”
Many economists still assume the market failure of'pure public goods'. Samuelson
is obviously the first and the most famous and mathematically formulated his rationale.
Foldvary and others' works, such as club theory (Buchanan, 1965), present the other side of
as national defense, better public decision, etc.
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the issue. The two sides seem to be totally opposite to each other. What is their real
difference? What is common to both sides? A further question is: what is the real reason for
'market failure'?
The most obvious difference between the two schools is the scope o f the object. In
Samuelson's formulation, the individual is the unit o f analysis. The market is composed of
individuals among whom there is no relationship except the market mechanism. However, in
Buchanan and Foldvary's studies the analytical unit becomes a club or a community. Then
the market relies on competition among the clubs or communities. The price signal works
when each individual buys his or her entrance to the clubs or communities. But what
happens after they obtain the right to the clubs or communities? Certainly new governance
replaces the market mechanism within those clubs and communities. The approach o f the
latter school is analogous to the traditional theory o f the firm, which emphasizes the
production function o f firms but never questions the reason for their existence. In an
opposite direction, the approach o f the former school looks like regarding only the spot
market as the market and no firms or other organizations existing as necessary components of
the market. Following Coase's famous question (1937), two similar questions can be asked
of the two schools respectively: What is the rationale for organizations in the market? Why
couldn't the club/community be big enough to include all the people? These two questions
obviously point to the importance o f institutions in our understanding of the market.
In this sense, the two sides share a paradoxically common ground in terms o f the
methodology. They both pay little attention to the role o f market as institutions and the
contracting problems in providing ‘public goods' over time. They either dismiss the
existence o f various social, economic or political organizations, or are interested in only the
■production function' o f those organizations— providing territorial collective goods. History,
process, and the consequent contracting issues thus disappear. The market is only left with
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'atomistic and natural' individuals or organizations. An individual-only model naturally
assumes the absence o f any social relationships (such as culture, morality, law. and etc.)
among the individuals, while a club-only model never questions why the club comes into
being and how its internal functions are different from the market. The efficiency arguments
for both models only take into account the provision efficiency o f collective goods, with
nothing considered for transaction costs and risks or uncertainties related to the whole
process. In a word, they are developed in the vacuum o f institutions and property rights.''
It is now much easier to understand the concept o f market failure. Only in a vacuum
of institutions and with atomistic individuals does market failure become the inevitable result
in the provision of collective goods. Even the existence of clubs and private communities is
the result o f the market process, and they are part of the market. Being endogenous to the
market, various institutional arrangements and the consequent forms o f property rights and
organizations are the symbols o f market success instead of market failure. In this sense
market failure implies an ignorance o f institutions and property rights.
Although the concept of public goods is often regarded as the source o f market
failure, as shown by Samuelson (1954), once the institutions and property rights are taken
into account it soon becomes very clear that the reason for the concept o f public goods is
actually the 'belief in market failure. That is. whenever we talk about public goods we are
assuming some particular institutions and institutional environment. I f the exogenous and
atomistic institutional assumption is dropped, the concept o f public goods loses its
foundation. For public goods, Jean-Jacques Laffont had the following comments:
'* In a famous critique on transaction cost economics, Granovetter (1985) pointed out the undersocialized
conception o f human action in classical and neoclassical economics, in contrast to the oversocialized conception
in sociology. The two sides herein obviously look for undersocialized resolutions to the problem o f public
versus private provision o f collective goods.
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Ultimately, optimization o f economic activities by property rights
defines the goods to be exchanged and their different properties,
namely exhaustibility or nonexhaustibilitv by individual use.
exclusion or non-exclusion, required subscription or optional use. etc.
Hence the definition o f goods is endogenous, not exogenous.
( Laffont. 1988. p. 35)
In his taxonomy of economic goods, technical and institutional distinctions contribute to the
categories o f public goods. So by introducing endogenous institutions and property rights,
the theory of market failure collapses because even the concept o f public goods may not be
valid any longer. What is public versus private depends then on the property rights and
institutions.
A similar critique was raised by Bouckaert (1987) and Covven (1988). albeit from the
perspective of the role o f technology in the provision o f public goods. When Cowen
reviewed Goldin's argument (1977) that technology determines the feasibility o f producing
collective goods in a selective access mode, he further cautioned about the feedback effect.
“ The unavailability of a suitably cost-effective exclusion technology may be due to the public
sector's monopolization o f the provision o f the good or service." This is based on
Bouckaert's hypothesis that “ the 'pubiicness' o f many o f the goods and services supplied by
the public sector is a result o f their public provision, not a cause of if" (Cowen 1988. p. 6).
Since technology is the driving force behind the progress o f our society and the evolution o f
economic and social institutions, in this sense their critique is complementary to the argument
that 'public good' is endogenous to the institutions.
Bundled Consumption vs. Provision Bundling
The concept o f territorial collective goods itself suggests that many goods including
both collective goods and private severable goods are bundled together within some territory.
When a user buys or leases a parcel o f land, he/she pays not only for the private good (in this
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case, land and building for residence or business) but also for the collective goods tied to the
land. These collective goods may be produced and provided at different levels depending on
the notion o f territory. They range from those provided at the higher levels o f socio
economic organizations, such as national defense, to those at the very low level such as
security service for a shopping center. So the ground rent actually reflects the market
demand and supply of both the private goods and the collective goods that are bundled
together. The fact that territorial collective goods and the land space as a private good are
bundled together has great impact on property rights and urban institutions.
The bundled consumption o f the private goods and the collective goods poses a
serious problem to the traditional analysis that focuses on only abstract 'pure public good.' In
Samuelson's work (1954) he distinguished the Pareto-efficient criterion for public goods and
private goods. For private goods, the marginal rate o f transformation should be equal to each
user's marginal rate of substitution. But for the public goods, the marginal rate o f
transformation should be equal to the sum of the users' marginal rate o f substitution. This
result then leads to the conclusion of the failure o f any decentralized pricing system to
achieve the optimality in collective consumption. Implicitly he assumed two separate
economic systems for private goods and collective goods. However, if they are bundled
together, as in the case of territorial collective goods, what system can be used to determine
the optimal levels o f collective consumption? It is obviously impossible to completely
separate the two systems for a bundle of both kinds o f goods.
In the real world, the prevalent form o f local public service is that local government is
responsible for providing public service while land is transacted in a decentralized pricing
system— the market system. This looks like the only feasible solution in Samuelson's model.
It is exactly because the consumption o f land is bundled with local public services that gives
rise to the various efficiency and equity issues o f this system. For example, local public
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services are capitalized into land prices, benefiting only those people who own the private
good— land. This was definitely the motivation behind Henry George's theory'. On the other
hand, in a political system the level of local public service determined by people who are not
necessarily landowners may negatively impact the landowners. Hence, even though each
system may be theoretically efficient for each kind o f good respectively, their simple
combination may change their efficiency properties for the bundled goods.
The same is true for property rights. For the two aspects of a real property— private
good and related territorial collective goods, since they are attached to the same physical
entity and are simultaneously transacted and priced together, any legal system o f property
rights will affect the consumption of both kinds o f goods at the same time. Therefore, a
possibility arises that a property rights system that is efficient for one good may be less
efficient for the other. Like any other private good, a fee simple ownership o f the ‘private"
aspect of the property may be the most efficient system, but it has been proved not efficient
in terms of the collective goods attached to the property, as argued by Samuelson (1954). If
all users lease the land from the owners, it is efficient in the sense that it effectively reveals
the demand for the territorial collective goods and leads to efficient provision o f those goods
(MacCallum. 1997). But it may not be efficient for the consumption o f the private good that
the user wants to occupy, as w ill be discussed later in the paper. So how can we trade off
between the different forms o f property rights? Or. what are the conditions for an ‘ideal'
form of property rights that are both efficient in the provision and consumption o f both kinds
o f goods tied to the same property'? To push the question further in the other direction, can
we separate the two kinds o f goods? O f course it is impossible to separate their consumption
from the physical entity, but their provision and financing can be separate.
Many people have studied the tie-in issue. Coase's study (1974) o f Eighteenth-
century British lighthouses is a classical case. Cowen (1988) listed shopping malls as an
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example o f the use o f tying arrangements for public goods supply. He argued that public
goods such as streets and security are paid for through the provision o f private goods such as
shoes, clothing and books. A problem in his argument is obvious. The private good that is
really tied to the ’public goods' is land instead o f shoes, clothing and books, and the
collective goods are paid for through rent. Klein's study (1987) focused on the tie-in issues
and tried to bridge public finance and industrial organization by introducing transaction costs
into the topic. The transaction costs in his study include the marketing costs for the firm and
the purchasing costs for the consumer. He analyzed the parallel between tie-ins and the
Tiebout model o f competing communities. Complementarity in consumption is the
determining factor to the tie-in arrangement, and economies o f scale and scope are the
secondary ones. “ In general, goods o f high consumption complementarity w ill be strong
candidates for tying. As we move further away from perfect complementarity, tie-ins may
still be used as long as exclusivity increasingly comes into play to prevent free riding" (Klein
1987. p. 468).
In Klein's analysis o f tie-ins there are several important pitfalls that are more or less
shared by others. The first problem is the failure to distinguish the bundled consumption and
the bundled provision. Bundled consumption of the private good (land) and the collective
goods is a spatial fact in the case o f territorial collective goods, regardless o f property rights
and institutional arrangements. This is where the spatial dimension matters. But the bundled
provision or production o f both kinds of goods is not a physical fact but an issue o f property
rights and institutions. In this sense, Cowen raised a wrong question when he said that “ there
has never been a systematic effort to ascertain the exact conditions under which public goods
tying arrangements w ill be both stable and beneficial'' (1988. p. 10). The real question
should be: Under what tying arrangement for the provision o f public goods w ill their
consumption be both stable and beneficial? In the example o f shopping malls, the optimal
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combination o f the consumption of private goods (shoes, clothing, etc.) and collective goods
is largely determined by the consumption technology in terms o f Lancasterian utility'. But the
optimal provision o f them depends on property rights and institutional arrangements.
Second, he failed to distinguish between production and provision, producer and
provider, and transaction costs are treated like the production costs in the neoclassical way.
Economies o f scale and scope may impact production efficiency, but the provision process
may be quite separate from the production process. Economies o f scale and scope can
always be assumed away since the provider is not necessarily the producer. Throughout
Klein's paper little is considered for the uncertainty in contract execution stage and the
distinction between ex ante and ex post stages in the economic processes.
Third, tie-in arguments based on technical complementarity are superficial.
Obviously complementarity is related to the mutual interdependent relationship. But it is
more a technical term instead of an economic term. It has no real implications for the
relationship between the provision of one good and that of the other. Consumers can always
do ‘home tie-ins* by themselves. Assuming product A and B are perfectly complementary
does not necessarily mean that their producers (C and D) have to rely on each other or their
provisions must be bundled together, although it may be desirable. If A and B are not asset-
specific and are quite standard, then consumers can easily find another producer E who also
produces B to match product A made by D. Here it is the market that is performing the
matching and aggregating function. So the real question should be what is the line between
'home tie-in" and tie-in arrangement? From the perspective o f transaction cost economics,
the real reason behind the ‘tie-in* phenomenon should be asset specificity (Williamson 1985).
Fourth, Klein argued that “ assuming free riding is avoided, tying w ill be
advantageous only to the extent that people generally want all the goods in the bundle"
(1987. p. 468). People's demand is just a very general answer to the question why tying
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exists. The real issue lies in the capitalization o f a particular good on the price of the bundle
as well as who controls the residual rights--the incentive problem. Klein was obviously
wrong when he said "whether or not a good w ill be tied to a set of other bundled goods will
depend in part on the value o f that good" (1987. p. 469). It should depend on to what extent
it is capitalized in the price o f the bundle.
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21
CHAPTER 3
GOVERNMENT FAILURE AND THE TIEBOUT MODEL
‘ Market failure' theory often leads people to the conclusion of government as the
only capable provider of public services, and the consequent clear distinction between public
and private sectors. This black and white rationale is nai've. not only in the sense that it
regards the market as a collection o f atomistic individuals but also because it overlooks the
inherent problems in government provision o f civic goods. In this chapter, the economic
inefficiency o f the political process and the failure o f the Tiebout Model will be discussed in
the context o f a market economy and a democratic government. The focus is on why
political processes could not replace economic mechanisms in terms of economic efficiency.
O f course, the importance o f the political process to the other aspects of our socio-economic
system should not be simply assumed away even though it is not our interest here. In
addition, the central planned economy in former socialist countries will not be discussed here
because its ‘fatal conceit' problem (Havek. 1988) is well-known.
Vote-by-property versus Vote-by-head
Even if the market (in its narrowest definition, i.e., spot market with atomistic
individuals and no other institutions) fails to provide the optimal level o f collective goods,
does this inevitably lead to the provision of collective goods by government? Both
theoretical arguments and empirical evidence suggest that government provision o f collective
goods is far from efficient due to the nature o f the political process. The main reason listed
for the government provision o f collective goods is the problem o f free riding and demand
revelation in the market system, but government faces another kind o f problems o f free rider
and demand revelation due to its incentive structure and the voting process.
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Since most civic goods are territorial collective goods, they benefit all residents or
users within the territory. In this sense they are capitalized into all residents/users' ground
rents and are collected by the landowners. Financing the provision of these collective goods
is from the tax revenue of the government, especially the property tax for the local
governments. Property tax is o f course proportionate to the property value. So if the territory
is homogeneous in terms of land value and everybody owns a same-size parcel o f land, it
seems that the owner can benefit from the capitalization o f any improvement in the provision
of civic goods that are financed by his/her contribution of the property tax. It sounds both
efficient and equitable. However, even in this idealized setting, the incentive structure and
the agency problem will still distort the process and result in inefficient provision o f the civic
goods.
The basic distinction between government and market is their incentive structures.
Politicians are not awarded by making money, but by catering to the appetite o f the voters.
The fact that voters have different preferences for different civic goods means that some
people's demand will not be satisfied while the others' are exaggerated. Coercion is the
major method used by government to finance the provision o f collective goods. It is obvious
that this imposed governance in the political process cannot achieve the same level of
efficiency as consensual governance (Foldvary, 1994).
On the other hand, the agency problem also plagues the political process. Politicians
have their own interests in the positions and their goal can not be expected to be completely
aligned with the interests o f the property owners. Due to limits on the term o f the public
positions, they are eager to serve the interests o f current voters while no voice o f future
generations can be heard. The shortsightedness o f the politicians is another source of
inefficiency in the provision o f public services.
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When the idealized setting o f equal property ownership is removed, the vote-by-head
process suffers more problems in terms of economic efficiency. The distribution o f political
voters, especially in a plebiscite, is far different from the distribution o f dollar votes o f
property values. Because the property tax is tied to the property value, people with less or no
property tend to reveal a stronger demand for civic goods because they are free. Meanwhile,
those with more properties tend to hide their demand and turn to the other ways to consume
civic goods. The revealed demand for ihese collective goods is then distorted and the free
rider problem is further aggravated. Thus even without agency problems, a vote-by-head
process will be much less efficient than a vote-by-property process.
In real world politics, which is plagued by race, wealth and etc.. the theoretical
arguments for the inefficiency of the political process are corroborated by empirical
observation. On the one hand, James Madison in 1790 criticized the evils in the 'small
republic", which were subject to populist laws. Fischel (1995) argued that, by comparing the
size of the states in 1790 to the current municipalities, "municipalities are the current
repositories o f the majoritarian excesses about which Madison worried." Along this line of
reasoning, fast developing transportation and telecommunication technologies w ill make it
more likely that majoritarian excesses w ill expand spatially . On the other hand, special-
interest politics is very active and rent seeking is a common characteristic o f politics
(Buchanan, Tollison and Tullock. 1980). These special-interest groups have great influence
in determining the provision of various civic goods. In either case, an efficient provision of
collective goods could not be achieved and the basic economic problems remain.1 1 1
1 0 Fischel (1995) proposed that "the political process would normally be sufficient to protect property interests in
larger jurisdictions." and the problem lies in small, local governments. He thought that is why judicial
review/scrutiny is necessary for regulatory takings. But as to providing civic goods, since most civic goods are
provided at the local level and the judicial process could not be simply assumed to be efficient, this method is
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Exit and Voice
As Hirschman (1970) argued, people w ill resort to either exit or voice when they face
inefficient provision of collective goods. On one hand, they can either simply leave the
jurisdiction for better provision o f collective goods, or exit in the sense that they can consume
collective goods through the private sector without caring much about the political process,
as long as the consequences o f the political process are not too excessive. On the other hand,
they can express their dissatisfaction and use their votes to influence the decisions o f the
government. The latter is the voice option. However, the exit option is much less efficient to
create immediate pressure on politicians than on firms, and the nature o f collective goods
further exacerbates the problem. First, the demand for the government provision o f the
collective goods is quite inelastic with respect to quality changes, at least for a short period of
time, because the political process cannot reveal the market demand and the provision of
those goods is more or less a monopoly. Thus it is difficult for politicians to get the message
that something is amiss, and even if they get it the changed population base w ill further
strengthen the majoritarian excess. Second, even if a person can exit from the provision of a
particular collective good, he often cannot stop being a consumer of the other collective
goods that are bundled together with the one he exits from. For example, if he sends his child
to a private school, he and his child's lives still face the impact of the deterioration o f public
education in the neighborhood. 'The concept o f public goods makes it easy to understand the
notion that in some situations there can be no real exit from a good or an organization so that
the decision to exit in the partial sense in which this may be possible must take into account
any further deterioration in the good that may result’' (Hirschman, 1970. p. 101). Hence a
doubtful.
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partial exit may solve the problem in the short run, but certainly not in the long run. Third, as
will be discussed later, a complete exit option is also limited because o f the large transaction
costs involved in moving out o f the jurisdiction.
In this sense voice should be more important in influencing the provision o f collective
goods, given the much smaller number o f available providers than commercial products. But
the incentive structure o f the political process is determined by the vote-by-head rule.
Politicians are only interested in the demand o f the majority o f the voters instead o f those
marginal people who suffer most from the inefficient provision o f public services.1 1 In
conclusion, "exit did not have its usual attention-focusing effect because the loss o f revenue
was not a matter o f the utmost gravity for management, while voice did not work as long as
the most aroused and therefore the potentially most vocal customers were the first ones” to
exit (Hirschman, 1970, p. 45).
Although Hirschman regarded the wide latitude people usually have for deterioration
“ is the inevitable counterpart o f man's increasing productivity and control over his
environment” (1970, p. 6), in the long run the situation is not so pessimistic. The
'spontaneous order’, i.e.. various social arrangements and institutions, w ill emerge as a result
of social evolution (Hayek, 1988). Therefore, in the short run we may see futile exit and
voice for the provision of collective goods, but over a longer period o f time new institutional
arrangements emerge.
One model o f the exit option is the Tiebout Model, which emphasized the efficiency
gains through inter-governmental competition. As discussed before, the political process for
providing collective goods is inherently inefficient. Nevertheless, this point does not
1 1 O f course there are marginal people on the two ends. Some may not be satisfied with the current levels of
certain collective goods, while those on the other end may be craving for more o f some other collective goods.
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necessarily preclude that pressure from the inter-governmental competition could not result
in efficient provision of collective goods as long as people can effectively exercise their exit
options. But is this really a feasible and efficient way?
Failure of Tiebout Model
It has been shown that the bundled consumption o f collective goods has posed a
problem to an efficient system o f local public finance. However, if people can move freely
and choose different bundles o f collective goods and private goods, an efficient local
residential pattern may be achieved as a result o f the competition between local governments
and voluntary 'combinations' o f residents and local governments. Based on this premise.
Tiebout (1956) developed a model o f local public finance and demonstrated that an efficient
pattern o f local services can be achieved by residents voting with their feet for local public
service. Along this line of reasoning, Hamilton (1975) argued that the value o f local services
w ill be capitalized into residential values and in the long run supply responses w ill eliminate
this capitalization. Although Tiebout did not consider property tax and capitalization, in
Hamilton's model fiscal zoning becomes necessary to restore efficiency in the context of
property tax.i: On the other hand. Yinger (1982) pointed out the importance o f the local
voting process and the property tax. He suggested that local services can not be completely
capitalized even in the long-run equilibrium. Property taxes distort the housing market.
Movers reveal their preferences through the bids for housing, not through their choice of
jurisdiction and therefore do not necessarily obtain efficiency. He concluded that household
1 2 The Tiebout-Hamilton model is even regarded as more efficient than Henry George's model by Fischel
because it "contains a demand-revealing mechanism— voluntary location and majority voting by a relatively
homogeneous group— as well as an unavoidable tax" (Fischel, 1995, p. 260). Obviously Fischel looked more at
George's proposal o f a single tax instead o f his insight on ground rent.
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mobility is not sufficient to generate efficiency. "Efficiency depends on the political process
of voting, not just on the market process of choosing a community” (Yinger. 1982).
The debate on the efficiency of the Tiebout Hypothesis is largely centered around
capitalization and property taxes. In those models institutions are regarded as exogenous and
many institutional assumptions are taken for granted such as property rights and the
distinctions between homeowners versus renters. Although many researchers indicate that
perfect mobility in the Tiebout Model is not practical in the real world, they fail to study its
implications in property rights and institutions. In the real world, t ' . v ante actions will in the
long run be affected by ex post results. This is the basic economic reason for institutions and
institutional change. In general, two inter-related problems are overlooked: (1) the difference
between land users and land owners. (2) ex post immobility versus ex ante choice.
Land users are not necessarily landowners. Land users can lease the land from the
owners and do not need to buy the property. So we can regard renters and owners as two
different groups o f people.lj The owners collect rent and benefit from the capitalization o f
local services, but they have to pay the property tax if required. The renters pay for the
benefits of local services. They do not have any residual interests in the property and could
not benefit from the capitalization of local services. The renters are mobile and can shop
around for the optimal bundle o f local services that best satisfy their preferences. But the
owners are free to choose among different jurisdictions before they buy the property. After
the purchase o f the property, their mobility greatly diminishes because o f the large
transaction costs in selling and buying the property. In this sense they are subject to the
uncertainty of property value due to their ex post immobility. That is why when Fischel
1 ’ in Yinger's work (1982) he distinguished the movers and the residents. The former shop around for the
optimal bundle o f local services while the latter vote for the provision of local services. This distinction is not
enough for what we are interested here.
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discussed the issue of regulatory takings he said, "local regulation of immobile assets should
receive more judicial solicitude than other regulations" (Fischell. 1995. p. 100). This ex post
immobility of landowners certainly reduces the efficiency of the Tiebout Model, which is
already distorted by property tax and capitalization.
Another implicit assumption in the Tiebout Model is that people shop around only for
the optimal package o f local services. As mentioned before, the major purpose o f people's
using land is to consume the space as a private good instead o f only the collective goods.
Boudreaux (1998) pointed out that "individuals make locational decisions for many reasons
other than the discretionary offerings of local governments, which may severely limit the
alternatives among governments that individuals actually have." The use o f space as a
private good is the traditional treatment in urban economics, as shown in the traditional urban
economics models (Alonso. 1964: Mills, 1967: Muth, 1969: Wheaton. 1979). Obviously
these two branches are not well combined. When the private-goods aspect of property is
taken into account, the Tiebout Model is seriously weakened in terms o f both mobility and
choice.
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29
CHAPTER 4
THE FUNDAMENTAL TRANSFORMATION AND THE EFFICIENCY OF
GROUND LEASE SYSTEM
The ex ante choice versus ex post immobility poses a basic problem to each
landowner. It seems impossible to obtain optimal levels o f collective goods given the
inefficiency in the political process. Even if it is possible to reach an efficient pattern o f local
public services, as described by the Tiebout Model, the bundled consumption o f land and
collective goods invalidates possible efficiency gains. Furthermore, there is always
uncertainty in the provision of collective goods due to the nature o f politics. Simply moving
out can not avoid the problem without incurring high transaction costs, and it cannot
eliminate or even reduce the uncertainties embedded in the political process. Maybe in the
short run people can deal with these problems by just tolerating them or exercising inefficient
exit and voice options (Hirschman. 1970). In the long run. interactions among people and
their trial-and-errors w ill evolve over time and result in various forms o f property rights and
institutions to increase economic efficiency.
Transaction Cost Economics and the New Institutional Economics
Transaction cost economics is part o f the New Institutional Economics. Williamson
(1985) summarized the features o f transaction cost economics as compared to other
approaches to economic organizations:
[Transaction cost economics (1) is more microanalvtic. (2) is more
self-conscious about its behavioral assumptions. (3) introduces and
develops the economic importance o f asset specificity, (4) relies more
on comparative institutional analysis, (5) regards the business firm as
a governance structure rather than a production function, and (6)
place greater weight on the ex post institutions o f contract, with
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special emphasis on private ordering (as compared with court
ordering). (Williamson, 1985)
Williamson distinguished transaction costs of ex ante and ex post types. The former
are the costs o f drafting, negotiating, and safeguarding an agreement. The latter include (1)
the maladaption costs as a result o f ex post misalignments. (2) the haggling costs. (3) costs
related to running the governance structure, and (4) the bonding costs o f effecting secure
commitments. Furthermore, the ex ante and ex post costs are interdependent.
Transaction cost economics starts with the analysis o f the firm. It tries to explain the
existence o f the firm in a market economy. By being bound by a contract, the parties to a
transaction can lower the transaction cost of discovering relevant prices and the costs of
negotiating and concluding a separate contract for each exchange transaction in a market
where the price mechanism dominates (Coase, 1937). Cheung (1983) emphasized the role of
transaction costs in creating the firm when the savings o f transaction costs is equal at the
margin to the agency costs in the factor market. Among market, hierarchy (such as a firm
within which the price mechanism is suppressed) and their hybrid forms, which one is more
efficient than the others depends largely on the extent to which the parties share
interdependent relationships (Williamson, 1975, 1979, 1985). Opportunism and bounded
rationality are two comer stones in the behavioral assumptions o f transaction cost economics.
In Williamson's words, the organizational imperative becomes to "organize transactions so as
to economize on bounded rationality while simultaneously safeguarding them against the
hazards o f opportunism'’ (1985, p. 32). With opportunistic agents, the higher the mutual
dependency, the more probable that one party is going to be taken advantage o f by the other.
On the other hand, bounded rationality determines that no contract can be complete in that
future events can not be fully anticipated in advance, even though the costs o f drafting
contracts are totally ignored. From these two assumptions it follows that the more
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interdependent are the parties to the transaction, the more likely they are going to be
integrated into a hierarchical institution. Transaction cost economies are realized by
assigning transactions with different attributes to governance structures in a discriminating
way. That is also why comparative institutional studies become the main method in
transaction cost economics.
In order to measure the different attributes o f transactions and the extent o f mutual
dependence, three dimensions o f transactions are identified: asset specificity, uncertainty, and
frequency. The most important one is asset specificity, which defines the degree to which
assets in an investment contribute to the loss o f one or more parties if they want to use the
assets in another way.1 4 Williamson (1985) listed four types o f asset specificity: site
specificity, physical asset specificity, human asset specificity, and dedicated assets. But what
is the reason for the parties to a transaction to choose special purpose versus general purpose
investments? As suggested by Adam Smith’s famous theorem— "the division o f labor is
limited by the extent o f the market", there is a tradeoff between the prospective cost savings
from special purpose technology and the strategic hazards as a result of their nonsaivageable
character. This tradeoff introduces the other two dimensions o f transactions: uncertainty and
frequency. On the one hand, more uncertainty definitely increases strategic hazards. For
idiosyncratic investments, increasing the degree of uncertainty w ill make it more imperative
for the parties to engage in certain institutional arrangements in order to reduce contractual
gaps and the related behavioral uncertainties. On the other hand, higher frequency o f the
transactions makes it easier to recover the cost o f specialized governance structures.
u Williamson regarded asset specificity- as "the big locomotive to which transaction cost economics owes much
o f its predictive content” (1985. p. 56).
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So in Williamson’s framework, the more idiosyncratic the assets, the more uncertain
the ex post contract execution, and the higher the transaction frequency, the higher degree o f
reliance o f the parties upon each other. In other words, a more integrated form of
organization can prevent the parties from opportunistic behaviors in case o f unexpected
disturbances or risks that could not be avoided by ex ante contract due to the 'bounded
rationality'. The cost for this transaction cost economy is the reduction o f incentives within a
hierarchical organization.
Another branch of transaction cost economics is more concerned with the difficulty
of measuring performance or attributes associated with the supply o f a good or service.
Team production is an example o f technological nonseparabilities (Alchian and Demsetz.
1972). In all economic transactions, errors of measurement are too costly to eliminate
entirely, and people have to spend resources to acquire consequently different values of
equally priced goods. Various market arrangements, such as product warranties, share
contracts, suppression o f information, emerge to reduce the losses from exploiting the
measurement errors (Barzel, 1982). By extending the concept to vertical integration. Barzel
further argued that “ distinct firms will form and trade with each other at junctures where
output can be readily measured, but where output is difficult to measure the different steps
will be performed within the firm" (1982. p. 42). Compared with the governance approach in
transaction cost economics, which is concerned mainly with organizing transactions in such a
way as to facilitate efficient adaptations, the measurement approach focuses more on how to
better relate deeds to awards and minimize economic dissipation due to excess
measurement.1 3
I w ill discuss more about the measurement cost in the context o f property rights economics in the next chapter.
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Within the tradition o f the New Institutional Economics there is another important
branch that focuses on institutions and institutional environment (North. 1991. and others).
While transaction cost economics is largely concerned with organizations, the ” players". the
other branch is more interested in the "rules"— institutions and institutional change. For the
purpose of this thesis, the former is more relevant while the latter may be very important in
understanding the evolution o f property rights over time.
The Fundamental Transformation
Fischel (1995) showed an interesting analogue between racial minorities and
landowners. Why must racial minorities fight against discrimination? Because race is
immutable and because o f future uncertainties. For the landowners the logic is the same.
The c.y post immobility and the uncertainty for the future is essential for understanding the
situation of landowners with government as the traditional provider o f territorial collective
goods. The change from the ex ante choice to the ex post immobility demonstrates the
fundamental transformation that leads to various institutional arrangements including the
ground lease system.
In housing and other real estate investments, opportunistic behavior and moral hazard
problems are common as long as the parties are mutually economically dependent. The
reason is that nobody can fully anticipate all scenarios of the future and therefore the contract
cannot be complete. The case o f Pennsylvania Coal v. Mahons shows contracts cannot
prevent opportunistic behaviors and moral hazards.1 6 For territorial collective goods,
government does not have an explicit contract with each landowner although they may be
said to have a political ‘contract' with the majority o f people. Uncertainty around the
1 0 Cited from Fischel (1995).
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provision o f collective goods is much greater due to the nature o f the political process. As
long as the owner could not exclude free riders, full capitalization of any improvement can
not be realized. And for some collective goods, consumption w ill become congestible and
the landowners have to bear the congestion costs that cause land values to decline. In a vote-
by-head process, even when they are regarded as a group, no landowners can feel confident
that they can control the provision o f collective goods directly related to the property. Thus
for the provision o f collective goods the problem of opportunistic behavior and moral hazard
is not any better than those in commercial contracts. In addition, most territorial collective
goods have to be provided and exchanged on a continuous basis with high frequencies. This
further demonstrates the importance o f various institutional arrangements.
Land is also the classical example of an immobile asset. When he discussed the
organizational problems fora company town (1985, p. 35), Williamson distinguished two
scenarios— the immobile society and the mobile society . In the immobile society, the
workers' wage is conditional on. rather than independent of. the way housing is provided and
how the general store is owned and operated. Firm and site-specific housing investment then
makes home ownership by the mining firm coupled with efficient lease terms the most
attractive form of housing. The general store is better operated by a multiyear franchise or a
cooperative owned and operated by the workers. On the other hand, in a mobile society
characterized by automobiles, the need for site-specific investments in homes is greatly
alleviated and the exclusive reliance on the general store is relieved. In summary.
Williamson's company town model demonstrates the important contracting ramifications o f
mobility and asset specificity. However, it is important to note that the housing issue in the
company town example is largely concerned with the basic demands o f human life, or the
private good, in other words. In that case the "mobile" society can make land and home
ownership the most efficient choice. With economic growth and consequent affluence,
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common people's demand for collective goods such as security, environmental quality, etc..
may become more important in their decision making. Compared with the high mobility o f
other assets in a modem “ mobile'' society, land again becomes relatively more immobile.
Although an immobile asset in general does not pose a problem as long as it can be
transacted without much cost, land is not such a case. Though landowners enjoy plenty ex
ante choices and mobility, they are actually ex post immobile due to the high asset specificity
o f land.1 7 Common sense in real estate transactions shows how' much transaction cost it takes
to move a place o f residence. Among the four types o f asset specificity advanced by
Williamson (1985), land is absolutely site-specific. Investment in building structures
obviously belongs to physical specificity. Besides, human beings cannot live in a social
vacuum. They prefer to live within a network o f social relationships for various purposes. In
this sense there is human asset specificity, especially for residential real estate. Investing in a
house also to some extent means investing on your neighbors. Finally, many real estate
investments are strongly dedicated to personal- or firm-specific purposes. In conclusion, real
estate investment in modem urban society is a prime example o f asset specificity that
includes all four types o f asset specificity.
Boudreaux and Holcombe (1998) observed that location choices are costly to reverse,
and once a decision is made, individuals have little incentive to become involved in local
politics because that is also costly. This is exactly what Williamson (1985) meant by the
‘ fundamental transformation’ due to asset specificity, though he may say firms have little
incentive to be involved in litigation because that is very costly. After the ‘ implicit’ contract
is ‘signed’ by the landowner and the provider o f collective goods— local government, their
1 7 “Mobile” and “ immobile” are two polar situations for the convenience of theoretical modeling. In reality there
is always a degree o f mobility.
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relationship has changed fundamentally and they become interdependent. Even worse, this
relationship is not as symmetric as in traditional commercial contracts. The landowner
undoubtedly relies on the government to provide collective goods although they may not be
o f the kind, quality and quantity he/she wants. On the other hand, the incentive structure of
the political system does not indicate a strong reliance of politicians on each landowner
although it may be argued that local government is also more or less sensitive to the demand
o f landowners. This asymmetric relationship stems from the inefficiency o f the political
process, which is not characterized by voluntary transactions and unanimity. It exacerbates
the problem o f incomplete contracts and induces politically opportunistic behavior. Over
time this fundamental transformation leads to various institutional arrangements to
economize on transaction costs and increases economic efficiency. These institutions should
be able to integrate the interests o f the provider of collective goods and the residual claimant
o f the property. Their governance structure should be aligned with the asset specificity.
Williamson has summarized the organizational ramifications of different types of
asset specificity:
1 . Site specificity. Unified ownership is the preponderant
response to an asset specificity condition that arises when successive
stages are located in close proximity to one another. Such specificity
is explained by an asset immobility condition, which is to say that the
setup and/or relocation costs are great. Once such assets are located,
therefore, the parties are thereafter operating in a bilateral exchange
relation for the useful life of the assets.
2. Physical asset specificity. If assets are mobile and the
specificity is attributable to physical features, market procurement
may still be feasible by concentrating the ownership o f the specific
assets (e.g. specialized dies) on the buyer and putting the business up
for bid. Lock-in problems are avoided, because the buyer can reclaim
the dies and reopen the bidding should contractual difficulties
develop. Thus ex post competition is efficacious, and internal
organization is unneeded.
3. Human asset specificity. Any condition that gives rise to
substantial human asset specificity— be it leaming-by-doing or chronic
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problems o f moving human assets in team configurations— favors an
employment relation over autonomous contracting. Common
ownership o f successive stages is thus predicted as the degree of
human asset specificity deepens.
4. Dedicated Assets. Investments in dedicated assets involve
expanding existing plant on behalf o f a particular buyer. Common
ownership in these circumstances is rarely contemplated. Trading
hazards are nevertheless recognized and are often mitigated by
expanding the contractual relation to effect symmetrical exposure.
Paradoxically, greater aggregate hazard exposure can be mutually
preferred to less if, as a consequence, hazard "equilibration" is
thereby realized. (Williamson. 1985. p. 95)
But, if different (private or collective) goods are bundled together and they
demonstrate different types and degrees o f asset specificity, then what are the organizational
ramifications? This w ill be the central question examined in my analysis of CIDs.
Efficiency Properties of the Ground Lease System
Facing the fundamental transformation and ex post asymmetric interdependence,
what can landowners do to alleviate these problems? The market system in urban economy
has over time given rise to various forms o f property rights and urban institutions to enhance
its adaptability. I submit that the ground lease based land use system, as demonstrated by its
efficiency properties, is most efficient in providing territorial collective goods. Other
institutions, especially CIDs (Common Interest Development) w ill be analyzed later and
compared with the ground lease system.
In a ground lease based land use system, land users lease the land from the owner for
a certain period o f time. The owner is responsible for providing various territorial collective
goods such as security, street cleaning, etc., and even education. O f course the owner can
hire managers to perform these tasks, but the difference is not significant for the purpose of
my thesis. Commercial leases o f shopping centers and industrial parks are typical examples
o f this system. Within this system the landowner is the provider o f collective goods,
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although not necessarily the producer of those goods. The benefits o f these collective goods
are capitalized into the rent that tenants have to pay to the owner. For the tenants, they just
pay for the consumption o f the bundle of goods related to the land, including both land use as
a private good and various territorial collective goods. They are like ordinary customers
shopping around to find what best satisfy their preferences. However, unlike landowners,
they do not need to invest in land and therefore they are ’footloose' from any ex post
immobility. They keep both ex ante and ex post freedom at no significant cost. The match
between land users and the provision of collective goods is implemented through voluntary
exchange in the market. In this system, at least at certain levels, there is no role of
government if the land is not originally owned by the government. The communities (or.
'entrecoms' in MacCallum's terminology) are formed in the market, based on lease contracts
and are totally voluntary.
Actually what Henry George advocated is very similar to this ground lease system in
the sense that collective goods can be financed from economic land rent. Henry George
proposed a single tax equal to the land rent to finance public goods. Many scholars, such as
Stiglitz (1977). Vickrey (1977) and Tideman (1985), also theorized about funding "public
goods” from rent. Common ground among them includes an emphasis on the relationship
between the level o f public goods and maximizing land rent, assuming government as the
sole provider and tax as the sole tool, the absence of inter-community competition, and little
attention paid to the governance structure, incentive, transaction costs and institutions. As 1
have shown in the previous chapters, transaction costs, governance structure and institutions
do matter. Or else those models following George will lose their efficiency properties once
the reality is taken into account. Fischel (1995) regarded Henry George's system as less
efficient than the Tiebout-Hamilton Model. His argument has its merit in that the former
seldom considers inter-governmental competition and the problems associated with
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government taxation. However, if inter-provider competition can be taken into account with
appropriate institutional arrangements, then George's core idea can effectively incorporate
the merits o f Tiebout Model. It is exactly because o f this point that the ground lease based
land use system shows its distinct efficiency in providing territorial collective goods.
Where does the efficiency o f the ground lease system arise? First, the provider o f the
territorial collective goods is now the same one that owns the land and benefits from any
capitalization o f the collective goods into ground rent. The land user pays the rent for the use
right of the bundle o f private good and collective goods, while the landowner becomes the
residual claimant to the asset value o f land. The provider o f the collective goods and the
residual owner o f land value are now integrated into the same party. The problem o f the
fundamental transformation disappears because o f this internalization or integration. The
landowner no longer needs to worry about uncertainties in the provision o f the collective
goods. The governance structure is aligned with asset specificity in a transaction cost
economizing way. As Demsetz (1967) noted, "a primary function o f property rights is that of
guiding incentives to achieve a greater internalization o f externalities." The ground lease
system effectively internalizes the problem of territorial collective goods. Landowners are
induced to provide collective goods most efficiently. They are eager to exclude any
traditional externalities that might damage their property value. For example, when
developers lease the shopping centers they are very cautious to select the best combination o f
tenants.
In Williamson's framework, there is usually a tradeoff between low incentives within
the hierarchical governance structure and transaction costs in the market. The second
efficiency property o f the ground lease system is that at the local (neighborhood) level its
internal governance structure is very simple. It is often in the form o f owner - manager or
even a single entity— owner/manager, and the whole organization is very small. The only
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efficiency loss that may arise in the owner - manager structure is the agency cost, which is
common in the modem market economy. But at the local level this cost can be greatly
reduced, and therefore the intensity o f incentives can be maintained. Besides, the production
efficiency o f collective goods can remain intact because the provider needs not to be
integrated with the producer of those goods.
Third, by owning the whole territory o f collective goods, the landowner eliminates
the free-rider problem and makes the consumption of collective goods excludable. In the
ground lease system, as in any decentralized system o f market, the demand for the bundle of
goods is revealed through the price signal— land rent, and the supply response is now fully
elastic.
Fourth, the tenant is now footloose and no site-specific investment is needed. The
interdependence between the consumer and the provider of the collective goods is greatly
reduced and is no longer asymmetric. The governance structure is now the market, which
functions through voluntary exchange. In this sense, the ground lease system pushes the
consumer-provider relationship back to the market, albeit, at a new scale and from a different
direction. The governance structure and asset specificity are now aligned in a transaction
cost economizing way.
Fifth, now that the tenants (consumers o f the collective goods) are really mobile,
inter-community or inter-provider competition w ill bring an efficient pattern of providing
territorial collective goods. Efficiency from competition is the essence o f the Tiebout Model.
Thus only in a ground lease system can the efficiency gains from the Tiebout Model be fully
realized. Although the issue o f bundled consumption of private good and collective goods
still precludes a straightforward answer, its impact on inter-provider competition is limited as
long as there are enough number o f providers to choose from.
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Sixth, the consumption and provision o f collective goods now become market
behaviors and no political process is involved. Unlike the traditional model in which
government employs coercion as the means to finance and consume the collective goods, the
ground lease system is based on voluntary' transactions and voluntary governance. The usual
problems associated with political failure are avoided. Various problems embedded in the
Tiebout Model, such as the distortion by property tax. political voting, etc.. now all
disappear. Ceteris paribus, optimality can now be achieved in this system.
The Institutional ‘Spectrum'
Up to now I have analyzed many different forms of institutions o f providing
territorial collective goods. The efficiency properties of the ground lease system determine it
is the most efficient in terms o f providing local collective goods only. If we arrange all the
models in a sequence according to their efficiency in providing local collective goods,
starting from Samuelson, then Tiebut. etc.. the ground lease system is probably at the other
end. The difference between the provision o f private good and that o f collective goods
disappears in the ground lease system. In the short run. the collective goods are fully
capitalized into land value. The supply is fully elastic without any effect from property tax
and political voting. Zoning is no longer a necessary measure to exclude interlopers. In the
long run capitalization may disappear and an efficient spatial pattern can be achieved. In this
sense, the ground lease system should dominate the others in terms o f providing the territorial
collective goods alone.
If these institutions were arrayed in terms of the degree to which the landowner and
the provider o f collective goods maintained autonomy, government would be located at the
one extreme while the ground lease system at the other end. In the government model, the
provider— the government may have little relationship with the landowners other than some
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constitutional constraints. If monarchy is considered, the provider and the landowner are
then completely separated. But in a ground lease based land use system, the landowner and
the provider o f collective goods are integrated. Between the two extremes, various hybrid
institutions are in the middle o f the spectrum.
What determines the range? Or. what tradeoffs are involved? In the abstract sense, it
may be argued that there is a tradeoff between production costs (economies o f scale and
economies o f scope) and the transaction costs for these institutions. For example,
government o f the nation state is obviously very efficient in providing defense and justice.
However, in the context o f local public services, the production cost argument largely
vanishes because the scale is now more or less fixed and small. Besides, the production
process is not important in determining these institutions simply because the provider o f the
collective goods needs not necessarily to be the producer.
The question is basically asking what justifies the other institutions that are not as
efficient in providing territorial collective goods as the ground lease system. The answer lies
in the basic spatial fact that territorial collective goods are always consumed together with the
private good— land. Even though the ground lease system is most efficient in terms of
providing territorial collective goods, it may not be as efficient in terms o f the private good.
So there are basically two layers of spectra for the institutional arrangements in providing
local collective goods. One is for the private good, for which sole ownership may be the
most efficient governance structure.1 8 The other is for the collective goods, for which the
ground lease system is most efficient ceteris paribus. The fact that they are tied together in
consumption means that their respective institutional arrangements could not be completely
181 will discuss in the next chapter various determinants o f property rights for a private good. Sole ownership is
obviously not the only choice.
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synchronized. There is always a tradeoff and compromise. It is exactly because o f this
reason that we see so many different forms o f institutions in providing local collective goods.
Furthermore, the tradeoff depends on the relative weights people assign to the private good—
land and to the collective goods. These relative weights determine the interaction between
the two layers o f spectra.
A further question arises. If the limitation of local scale is abandoned, then what is
the limit o f the ground lease system? In other words, what is the tradeoff between various
organizational forms for territorial collective goods that are more general than local collective
goods? Williamson argued that "markets are often able to aggregate diverse demands,
thereby to realize economies o f scale and scope" (1985. p. 92). The implication is that
consumers can do 'home bundling’ themselves while the producers realize through market
organization the benefits o f specialization and the consequent economies o f scale and scope.
The limits o f the firm are thus determined by a tradeoff: "economies o f scale and scope may
be sacrificed if the firm attempts to make for itself what it can procure in the market: and the
governance costs o f internal organization exceed those of market organization where asset
specificity is slight” (Williamson 1985, p. 131). Therefore, fora bundle o f private goods and
collective goods, from defense, justice, education to street cleaning, what should be
provided at the local level versus national level and what should be provided in a ground
lease system versus through government taxation all depend on the tradeoff between
economies o f scale and scope and governance costs. When governance costs are high with a
decentralized organization, such as defense, an organization at the national level is desirable.
No provider is needed to bundle the provision o f a defense good with others, and consumers'
'home bundling' is efficient.1 9 When the governance costs o f market organization are lower.
I use the word ‘home bundling’ in the sense that consumers can directly procure the good from the producer
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such as street cleaning, a ground lease system is efficient by bundling street cleaning with
land. Then consumers' 'home bundling' is no longer desirable without inter-provider
competition. O f course, a completely decentralized system (i.e.. decentralized to each
person) is not feasible for collective goods due to its nature, and is also not necessary because
o f the small local scale.
In this sense, the ground lease system is also a perfect example o f lateral integration
since consumers procure some collective goods from outside, such as national defense from
the national government, and some other pre-bundled collective goods from the
landowner/provider. Hence, vertically there is also a hierarchy or spectrum o f institutions in
providing collective goods.2 0
without any prior bundling by any provider. It does not necessarily mean that the good must be exchanged in a
decentralized market system. For example, people directly consume national defense produced by the national
government without any provider bundling defense with a particular parcel o f land. In this case, the good is not
produced and exchanged in a market.
:o There are many complex phenomena in the real world. For example, a ground tenant may belong to a Home
Owners Association which provides some collective goods, as suggested by Prof. Harry Richardson in the case
o f Palm Spring. These kinds o f hybrid institutions reflect the complex interaction between the two layers.
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CHAPTER 5
GROUND LEASE VERSUS CID
In the previous chapters, I have analyzed the two extreme cases o f institutions for
providing collective goods— government and the ground lease system. From a theoretical
analysis, it has been shown that, due to the fact that consumption of the private good and that
o f territorial collective goods are bundled together, the ground lease system is efficient in
providing territorial collective goods but may not be efficient for the private good. These two
layers o f ’spectrums' certainly complicate the issue. Now the interesting questions are: If
these institutions move to the extremes, what are the economic reasons'? For those
institutions in the middle, what factors help to stabilize these hybrid institutions? Obviously
property rights and institutions do not evolve only in response to the provision process. The
other processes, such as the consumption process also matter.
MacCallum (1998) asked the question why CIDs have been spreading fast in
residential real estate while leaseholds dominate in commercial real estate."1 He called this
phenomenon a conundrum. The answer to this question is very important because it requires
the analysis o f those hybrid institutions in the real world. Only in this way can we
understand the determining factors behind the various forms of property rights and
institutional arrangements, especially the relationship between property rights and the
provision o f collective goods. The bundled consumption o f land and territorial collective
goods is the key to understanding the different patterns in residential and commercial real
:I CIDs include virtually all new subdivisions like condominiums and planned unit development (PUDs).
Residents in such development enjoy ‘common interests’ in public spaces as well as each other’s behavior if it is
determined to adversely affect the community. The developer usually sets up a homeowner association or
residential community association (RCA) that ‘runs with the land’.
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estate. In this sense the tradeoff between different forms o f property rights is ultimately
determined by the different preferences people have for the private good and the collective
goods.
Efficiency Properties of CID: The Transaction Cost Perspective
In residential real estate, the recent decades have experienced rapid development of
CIDs. The same problem that brings about the ground lease system, i.e.. the inefficiency in
the provision o f collective goods, made possible the growth o f CIDs. albeit, from another
direction. CIDs basically preserve the sole ownership o f land while establishing a more
efficient organizational form to provide collective goods.
In CIDs. each resident owns a parcel o f land but has a 'common interest' in the
streets and other common spaces. Decisions regarding the provision of collective goods and
controlling spillover effects of externalities are made by a mandatory homeowner association
(RCA), which was set up by the developer when the project was designed. Usually, only a
two-thirds majority vote can modify the RCA charter. In terms of providing collective
goods, the governance structure o f CIDs is like a half-govemment and half-firm entity. On
the one hand, only landowners within the CID are eligible to vote in homeowner association
affairs. This is very similar to vote-by-property. Capitalization of any improvements is
reaped by owners who have an equity interest in the property. The free rider problem is also
eliminated and the consumption o f collective goods becomes excludable. The whole process
is also based on voluntary exchange in the market and no coercion or imposed governance is
theoretically necessary. In this sense, the CID is like a firm and every one has an equity
interest in the homeowner association. But on the other hand, the CID is also like a small
local government. The owners still face the problem o f ex post immobility due to equity
investment in the property. Though the voting process is more like a vote-by-property one. it
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is largely still a political process and has many inefficient aspects. McKenzie (1994) listed
many problems o f CIDs. including ( I ) weak incentive structure and agency cost. (2)
inefficient decision making due to voting, (3) difficulty in aligning the interests o f residents.
(4) no possibility o f self-sustaining financing, (5) racial and religious exclusion, etc.
Nevertheless, from the transaction cost perspective, the hybrid nature o f CIDs does
increase efficiency and alleviate the problem of fundamental transformation. The provider
RCA’s incentive is aligned with the interest of landowners, since the RCA's control is
delegated by the landowners and the landowners have the final say in modifying the RCA
and its charter. In this sense the provider and the landowner are integrated, although in a
form more similar to modem corporations than to ground lease systems. The interdependent
relationship between the landowner and the provider is internalized within the CID. and the
transaction costs in the ex post contract-executing stage are greatly reduced. Asset specificity
is now aligned with the governance structure in a transaction cost discriminating way. Of
course, as a tradeoff, there are weak incentive structures and inefficient decision making that
are typical o f a hierarchical institution. But since property owners have the final say. these
problems are much less than in a ‘remote’ government, especially at the small local level.
CIDs also eliminate the free-rider problem and the consumption o f collective goods
becomes excludable. In this sense demand is revealed for collective goods. Furthermore, the
inter-community competition can bring about some efficiency gains as described by the
Tiebout Model, but the land users are no longer as foot-loose as in the ground lease system.
In conclusion, the half-firm, half-govemment hybrid structure of CID is an efficient form of
institutions for the provision o f collective goods even though less efficient than the ground
lease system.
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Then what justifies the popular growth of CIDs instead o f ground lease systems in
residential real estate? To find out about the tradeoff, it is necessary to turn to another aspect
o f institutions— property rights.
Property Rights Economics
The strong interest in property rights has produced a large amount of literature in the
past decades, and its growth is intertwined with those in the New Institutional Economics and
transaction cost economics. In the property rights paradigm the primary idea is that well-
defined property rights lead to more efficient use of resources and achieve better incentive
alignments (Alchian and Demsetz, 1973; Demsetz, 1967). The rights o f ownership o f an
asset include the right to use the asset, the right to obtain returns from the asset, and the right
to change the form and/or substance o f an asset (Furubotn and Pejovich. 1974. p. 4). Coase
(I960) shows that exchange by agreement is more efficient because goods w ill go to those
who value them the most. It is generally accepted that transaction cost efficiency is directly
related to the completeness of the right o f exclusion. However there are always positive
transaction costs because it is often too costly in the real world to perfectly delineate property
rights and enforcement costs are also high.
In a world o f uncertainty, the diminishing marginal utility of income is traditionally
the explanation for many market arrangements, and it is usually predicted that risk w ill be
borne by the party for whom risk is less costly. Barzel offers the measurement cost
explanation. No good for sale is free from the cost o f measuring its attributes. The buyer's
cost o f measuring the good, his demand, the good's price, and the seller's sorting practice are
all interdependent. Therefore various market arrangements emerge to minimize the
economic dissipation from excess measurements. Barzel argued that "whoever is in a
position to affect the odds w ill tend to assume the risk” (1982. p. 47). Thus, the most
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efficient owner is the one who can most influence the value or output and hence should be
the residual claimant to that value or output. He/she then has the incentive to increase the
value or output and economic efficiency is enhanced. In the property rights literature, the
example o f landlord-tenant relationships in farmland is often used to demonstrate this issue
(see. for example, Cheung 1969, Barzel 1989). If the output is largely determined by the
tenant whose input can not be easily monitored, then the most efficient form is a fixed rent.
However, if what determines output is the variability o f land and labor input is very standard,
then the most efficient form is a fixed wage. For sole ownership, its benefit is to avoid the
contracting problem and consequent transaction costs. But it loses the benefit from
specialization. Besides, for some factors such as labor, it is difficult to divide the ownership.
In a groundbreaking study, Sanford Grossman and Oliver Hart (1986) combine
property rights, contract and institutions into an integrated framework. Their theory o f costly
contracts classifies contractual rights into two types: specific rights and residual rights.
"When it is too costly for one party to specify a long list o f the particular rights it desires over
another party's assets, it may be optimal for that party to purchase all the rights except those
specifically mentioned in the contract. Ownership is the purchase of these residual rights o f
control" (Grossman and Hart 1986, p. 692). Whichever party o f the contract controls the
residual rights, the other party lost them. Hence by influencing each party's management
productivity in different directions the ownership structure affects ex post output which in
turn affects ex ante investment decisions. In this sense integration has both benefits and
costs. Hart (1995) further introduced the concept o f power and explored its relationship with
contractual incompleteness in terms o f the residual rights over actions.
Obviously, measurement cost is closely related to incomplete contracts. If there are
serious measurement problems and information asymmetry, it is more difficult and more
costly to specify a list o f particular rights over an asset. However, most studies in the
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property rights literature seldom consider what kinds o f goods are involved. There are
important differences in measurement costs between private good and collective goods. I
will explore the following two questions before comparing residential and commercial real
estate. Are there any special problems o f measurement cost and incomplete contracting that
are related to collective goods? Especially for territorial collective goods, what is the
implication o f bundled consumption?
Measurement Cost, Collective Goods, and Bundled Consumption
"Costly measurement is a factor common to ... instances where individual and joint
maximization do not coincide" (Barzel 1982. p. 28). This argument strongly suggests an
important role o f measurement cost for collective goods. The name of the collective good
itself means it is impossible to separate each individual's consumption. The reason lies in
measurement costs. Although it may be theoretically possible to devise various schemes to
reveal each person's demand and consumption, the consequent measurement costs are too
high to implement. Thus various institutional arrangements emerge to minimize
measurement costs. In this sense the measurement cost approach supports the argument that
the concept o f "public good" is endogenous to property rights and institutions.
Williamson (1985) categorized the measurement problems into two types at two
stages. The first is the idiosyncratic information at both the ex ante stage and the ex post
stage. That is, one party may have private information that the other parties cannot obtain
without high costs. The “ lemon market” (Akerlof, 1970) is a typical example o f this kind of
measurement difficulty." The second type, at the ex post stage, refers to the situation where
~ Akerlof (1970) used the example o f a used-car market in which only the seller o f a used car knows if the car is
a ‘'lemon.” For this reason, this type o f market is sometimes referred to as a lemon market.
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each party to the transaction knows the truth of what has occurred but it is difficult and costly
to disclose the facts to other people. This is one of the reasons for team production (Alchian
and Demsetz, 1972).
Both types of information asymmetry exist in the problems of "public goods". First,
only the individual knows his own ex ante demand o f the collective good and its ex post
contribution to his utility satisfaction, especially in the residential market. The free rider
problem basically originated from information asymmetry' embedded within the demand
revelation process. On the one hand. Arrow (1963) and others have demonstrated the
impossibility o f efficient public choice. On the other hand, even if some schemes can be
designed to induce everybody to reveal their true demand, the cost must be prohibitively high
or else there w ill no longer be the problem o f "public goods". Second, due to the nature of
"team consumption", it is difficult to disclose to others the degree to which each person
consumes the good even though everybody within the territory may know the truth.2 - 5
Besides, most collective goods involve congestibility and it is also difficult to distinguish and
disclose the source of congestion. In this sense the same information asymmetry problem
exists in “ team consumption" o f collective goods as in the classical example o f team
production.
Williamson commented that “ the relevant dimensions for ascertaining where the
measurement difficulties reside remain somewhat obscure" ( 1985. p. 81). Any information
issue, as well as measurement difficulty, is certainly related to the quality o f the good. Even
to count the quantity o f goods some standard for each unit (a quality characteristic) is needed.
Interestingly, the quality space raises a question that may link the measurement cost and the
:3 Even though it may be argued that each person encounters the same amount o f a collective good, it does not
necessarily mean that they all “consume” the same amount in terms o f its contribution to each person s utility
function.
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concept o f "public good". Is it possible that measurement cost is related to "public good"?
Auster (1977) argued that all qualitative dimensions o f products are collective goods,
especially ones of the "crowded” type. For the customers o f a firm's product, the level of
each and every characteristic o f that product is a collective good. For example, the color,
shape and taste of a particular brand o f orange are all collective goods to consumers in the
sense that they all encounter the same kind of color, shape and taste. Therefore every
physical good can be regarded as a bundle of private good (quantity) and collective goods
(quality). Then where does the measurement problem come as in Barzel's example of the
orange (1982. p. 28)? Barzel assumed that orange juice is the desired good, which is
obviously the private good, and then he argued that the measurement difficulty arises because
it is too costly to squeeze oranges. However, it should be easy to understand that once the
orange is bought by the buyer, it is no longer difficult for him to measure the amount of juice
either by his hand or by his mouth. But if the measurement problem is about the taste of the
orange juice, it persists even after the buyer can squeeze or eat it. The nature o f collective
goods determines the consumption/production process (the ex post stage) matters, while the
information asymmetry about the private good only matters at the exchange process (the ex
ante stage). In this sense the definition o f private good versus collective goods is endogenous
to the distinction between ex ante and ex post and that between exchange and consumption
process. In the orange example, since taste is a collective good, different people may have
different preferences for the same taste, let alone the fact that they may taste the same orange
juice differently. Thus for collective goods, the measurement problem cannot disappear at
the ex post stage, if any at the ex ante stage, while for private good only ex ante measurement
problems exist.
A ll economic processes in a market economy consist o f two parts: the
provision/exchange process and the consumption/production process, corresponding to the ex
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ante stage and the ex post stage respectively. So in terms o f information asymmetry and
measurement costs, it follows that collective goods play a relatively bigger role at the ex post
stage, while at the ex ante stage both private good and collective good are important.
What happens when the private good and the collective goods are bundled together?
In the Lancasterian utility theory and Auster's quality space, this is the normal instead of the
peculiar phenomenon. However, for generality. I am going to consider only the case in
which the consumption o f private good and that o f collective goods are bundled together in
the same physical entity.2 4 They are simultaneously transacted and priced together, and their
consumption could not be separated. Given that most forms of property rights studied in the
literature are only concerned about one good, it is then possible in the case o f bundled
consumption that a property rights system that is efficient for one good may be less efficient
for the other and the most efficient owner of one good may not be the most efficient owner of
the other. Thus, a tradeoff between different forms of property rights is needed depending
upon the particular features o f the bundled goods. But is the property rights form so fixed
and constrained? How do people usually solve this problem?
In the case o f an Austerian bundle o f private good (quantity) and collective goods
(quality), it is certainly impossible to “ divide" the physical good and apply different forms of
property rights to the private good and the collective goods respectively . It is also impossible
to let different people own the quantity and the quality separately. But people can own
and/or rent more than one physical good simultaneously and therefore effectively avoid the
disadvantages o f a particular form o f property rights. For example, it may be efficient for
one to own an economy car for daily transportation. But when one drives out to the
The bundling o f private good and collective goods in the provision process is more the result o f particular
institutional arrangement. O f course, with Auster’s quality space, this becomes true for all physical goods in
both the consumption and the provision processes.
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countryside, a 4WD or a truck may be more desirable. To solve this problem, he can always
own both o f them. Hence there is no fixed constraint from a particular form o f property
rights as long as one can own/rent more than one car simultaneously.
Things become different when it comes to the bundled consumption o f land and
territorial collective goods. "One can own more than one passenger vehicle, but the
individual is indivisible and must live in only one country" (Auster 1977. p. 430). Human
beings, as "land animals", are organized spatially according to various levels o f territories.
As a result people cannot own/rent territorial collective goods simultaneously, especially for
political territories.2 3 The complexity in property rights brought about by the bundled
consumption o f private good and collective goods is then inevitable.
Commercial versus Residential Real Estate
In my previous analysis I have shown that it is efficient for the landowner and the
provider o f collective goods to be integrated given the fundamental transformation due to
asset specificity. But is it efficient for the landowner and the land user to be integrated? In
other words, is sole ownership desirable? My analysis in the previous chapter focuses on the
provision process. Now I am going to focus on the consumption and production process of
the territorial collective goods.
It can be easily argued that in the production/consumption process, it is not efficient
to keep sole ownership for collective goods. Or else it does not make sense to distinguish
:s O f course, it is only a matter o f degrees that people are constrained by space. It may be argued that leasing and
the consequent mobility can effectively alleviate the problem by allowing the individual to “ live in different
countries" at different time points. But this is too costly and cannot totally eliminate the problem. A typical
example is national defense. A person is usually not allowed to enjoy defense protection from two countries.
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between collective good and private good.2 6 Their difference lies in the fact that the
consumption o f collective goods can benefit most from specialization and economies of scale
and scope, while for private goods the benefits from specialization may or may not be greater
than the consequent contracting costs. That is why the owner o f the territorial collective
goods is usually the government or the landowner instead o f the land users. In a word, for
both production/consumption and provision process, leasehold is efficient for collective
goods but for private good sole ownership may still be a viable alternative.
In the case of commercial real estate, the consumption of the private and collective
goods is the input for the production process, to which the output is the revenue generated.
The input o f the private good is very standard and can easily be measured by size, while that
of the collective goods is also relatively standard and can be easily monitored. There is
relatively less measurement difficulty for them, and it is consequently not difficult to specify
a list of particular rights that the space users want over the landowner's property. The output,
the revenue, can be easily monitored and measured, and is largely determined by the space
user's management and labor. Therefore, a fixed rent model is efficient so that the tenant has
a residual interest in the production process and is motivated to generate more revenue.
Nevertheless, in order to minimize the contracting costs from leasing, long-term lease
contracts are often observed in the commercial market.
If the input o f collective goods can not easily be measured and impacts revenue, i.e..
the ex ante and ex post measurement costs are high, then a share contract can be efficient.
Traditional explanations for the share contract are that it allows risk averse people to share
the risks. From the measurement cost perspective, sharing reduces the need for market
'b An extremely opposite example is that one person enjoys a separate school, a separate team o f fire fighters and
security guards, etc. Obviously, most people cannot afford it and it is not economically efficient.
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research (excess measurement) and the measurement error is limited to the sharing
percentage. "Share contracts rely even more fully on subsequent performance and obviate the
need for certain measurements at the time of exchange. Such contracts are expected, then,
when the determination o f the value o f the exchanged property at the time o f exchange is
exceptionally costly" (Barzel 1982, p. 32). O f course, share contracts are subject to incentive
problems absent from fixed rent contracts. Nevertheless, the percentage rent is quite popular
for commercial real estate. For them, sole ownership is not an efficient form o f property
rights because the benefit from specialization is too big to be lost. Therefore the transaction
costs from contracting is the price for the benefit from specialization.
But for residential real estate, it is a much more ’pure' consumption process. The
output, or the utility, certainly depends on the land users— residents. It is difficult to measure
how much utility they derive from housing, except by themselves. The measurement
problem is further aggravated by the fact that the consumption of residential real estate has
more than one purpose. People need to consider crime rates, environmental quality, jobs,
children's education, etc.. when they use a house. Even if the measurement costs for the
input o f the private good can be ignored, the measurement difficulty of output dictates the
efficiency o f sole ownership as well as the form of fixed rent. A share contract is no longer a
viable option simply because individual enjoyment or utility cannot be shared. For people
with a longer time horizon it is difficult to specify various particular rights over the property,
and thus it is efficient for them to acquire the residual rights. For people with a shorter time
horizon and simpler purpose, it is efficient for them to lease the space for a short time.
Although the latter group o f people can benefit from specialization and economies o f scale
and scope in the market, they have to pay a higher price for the contracting costs. This may
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be the reason why residential leases are usually short-term ones. So, generally for families
with a long time horizon, sole ownership is an efficient choice.2 7
As analyzed theoretically above, the bundled consumption of the private good and the
collective goods may cause the conflict between the efficient forms o f property rights for the
two types o f goods respectively. For commercial real estate, they are compatible with each
other and the ground lease system becomes popular. But for residential real estate, a trade o ff
is needed. The market responds in various institutional arrangements to minimize the
contracting costs and to adapt to the efficiency requirements of the private good and the
collective goods. The compromise obviously depends on the relative weights residents give
to the private good and the collective goods. The current dominance o f CIDs suggests that it
is an efficient solution. In the CIDs. the private good is owned by the resident while the
provision and consumption of the collective goods are controlled and monitored by the RCA.
Although the RCA structure is not so efficient in providing collective goods as the ground
lease system, it keeps two major efficiency properties: benefits from specialization and
economies o f scale and scope, and the alignment o f landowner and the provider.
The pre-designed RCA charter is another mechanism of property rights to reduce
information asymmetry and measurement costs. For any territorial exclusive organizations,
such as a club, bilateral information asymmetry exists. For example, if a person’s excessive
demand for collective goods is known to the others in the club, they wouldn't admit him: and
since they don't know, they must have already admitted many others o f the same kind earlier
(Williamson, 1985). However, if the organization’s rules restricts that person's behavior in
advance and he/she could not easily modify the rules, then the bilateral information
asymmetry problem is greatly alleviated. In the CIDs. the charters o f the CIDs are designed
1 1 O f course the choice of sole ownership depends on some other factors such as income and housing policies.
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in advance by developers and can only be amended by two-thirds majority voting. Therefore
any member's ex post consumption o f the collective goods and its externality effects are
largely limited in advance at the ex ante stage. The problems of information asymmetry and
measurement costs associated with the collective goods are solved, and the ex post
measurement difficulty and uncertainty embedded in any voting process are greatly reduced.
In conclusion, comparing with the ground lease system. CIDs can be justified by the
efficiency o f sole ownership in the private good, although it is very different from the
traditional fee simple ownership. Their difference is exactly where the efficiency o f CIDs
arises.
Ex Ante Ownership versus Ex Post Governance
The comparison between commercial and residential real estate shows that, in spite of
the efficiency in providing territorial collective goods, ground lease systems could not
dominate all other forms o f institutions for all types o f real estate. The efficient form o f
institutions is also affected by the consumption/production process and the effects o f private
goods. On the one hand, the fundamental transformation in the exchange process
necessitates the integration o f the landowner and the provider of territorial collective goods.
On the other hand, the fact that the consumption o f the private good and that o f collective
goods are bundled together makes it difficult for one form of property rights to be efficient
for all types o f real estate. The benefits from specialization and economies o f scale and
scope make leaseholds efficient for the consumption o f collective goods, but for private
goods the contracting costs from dividing ownership may be greater than the benefits. The
tradeoff between private goods and collective goods, between provision/exchange process
and consumption/production process, results in the dominance o f the ground lease system in
commercial real estate and the popularity o f CIDs in residential real estate.
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With its focus on the exchange process, transaction cost economics emphasizes the
role o f ex post governance in avoiding opportunistic behavior due to incomplete contracts
and asset specificity. The integration of the landowner and the provider o f collective goods is
a good example o f efficient ex post governance structure. The basic transactional feature of
CID structures ensures the alignment of asset specificity and the governance structure. It also
internalizes the problem o f ex post measurement difficulty and information asymmetry. The
pre-designed feature o f CID charters and the organizational difficulty to modify it serve two
safeguard purposes: reducing ex ante measurement costs and ex post uncertainty in collective
goods.
In contrast, property rights economics is relatively more concerned about how ex ante
property rights arrangement can reduce information asymmetry and solve the problems in the
consumption/production process. It is exactly because of the incentive intensity,
management skills and measurement costs in the production process that the leasehold is an
efficient form o f property rights tor commercial real estate. The same rationale supports the
sole ownership o f the private good in CIDs.
Williamson's comments on transaction cost economics summarizes the difference
between different approaches, although he failed to demonstrate how they are combined in
the real world, especially in a setting o f territorial collective goods.
In common with the property rights literature, transaction cost
economics agrees that ownership matters. It furthermore
acknowledges that ex ante incentive alignments matter. But whereas
the property rights and mechanism design approaches work within the
tradition o f legal centralism, transaction cost economics disputes that
court ordering is efficacious. . . . To ownership and incentive
alignment, therefore, transaction cost economics adds the proposition
that the ex post support institutions o f contract matter. (Williamson.
1985. p. 29)
The ground lease based land use system in commercial real estate is a perfect
example o f how a simple form o f property rights fits into different purposes. CIDs, however,
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illustrate the institutional complexity due to the combination o f private good and collective
goods, the provision/exchange process and the consumption/production process, asset
specificity and information asymmetry, and consequently ex ante ownership and ex post
governance structure.
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6 1
CHAPTER 6
LEASING AND MONOPOLY
Monopoly due to concentration o f land ownership has long been a concern for the
ground lease system. It is often argued that ground lease systems may help preserve the
concentration o f land ownership, which induces monopoly and inefficient monopoly pricing.
These arguments, on the one hand, reflect the legacy o f many social and economic
institutions in history such as the feudal system and the serfdom. On the other hand, they
may simply show the traditional orientation of neoclassical economics toward nonstandard
business practices. That is. the primary explanation for any nonstandard transactions that
deviate from the neoclassical market was monopoly. " [I]f an economist finds something— a
business practice o f one sort or another— that he does not understand, he looks for a monopoly
explanation" (Coase, 1972b. p. 67). But from an institutional perspective it seems difficult to
conclude that ground lease as a pure form of property rights induces inefficient monopoly
land price. The ground lease system requires the concentration o f land ownership to some
extent, but it does not necessarily result in monopoly. Instead, it increases economic
efficiency by economizing on transaction costs. So the real question is not whether a ground
lease leads to monopoly, but whether monopoly needs to use a ground lease to exercise
monopoly pricing.
Theories on Durability, Monopoly and Leasing
The ground lease system involves two issues that are possibly related to monopoly:
leasing, and the bundled provision o f private good and collective goods. The latter one is
often studied as tie-in sales. In the literature o f industrial organization there are two major
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approaches to monopoly with a focus on buyers: leverage theory and price discrimination.2 * *
Leverage theory maintains that nonstandard contracting practices can extend original
monopoly power, especially in terms o f the sale of complementary goods in the down-stream
market. But it is generally agreed among economists that the tying practice in these
circumstances cannot extend monopoly power but merely represents an effort to affect price
discrimination (Posner. 1979). The price discrimination approach, on the other hand, argues
that original monopoly power is unchanged and only latent monopoly power is realized
(Director and Levi. 1956). Tie-in sales are used by the sellers to discover underlying product
valuation differences among consumers and to monetize consumers' surplus.
There are two arguments emphasizing the relationship between leasing and the
exercise o f monopoly power.2 9 The first one belongs to the price discrimination approach.
Aaron Director argued that a firm with monopoly power over a durable good may choose
leasing the good to consumers while requiring consumers to purchase a complementary good
from the firm. In this way demand for the durable good is revealed by sales o f the tied good
and the firm can price discriminate among customers with different demands by raising the
price o f the tied good above marginal cost. This argument is relevant if we think o f the fact
that collective goods and the private good in a property are actually tied together. However,
since the value o f the private good and the capitalization of the collective goods are priced
together, it is difficult to measure the sales o f the collective goods in order to reveal the
demand for land itself. Therefore, this line o f thinking does not help us much on analyzing
the ground lease system.
:s Here I follow Williamson (1985. p. 24).
J > This follows La Croix and Rose (1995).
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Coase (1972) advanced the second argument. In the case o f a monopoly supplier
owning a completely durable good, he showed that "with complete durability, the price
becomes independent o f the number of suppliers and is thus always equal to the competitive
price" (Coase, 1972, p. 144). Thus suppliers o f a durable good cannot set a supra-
competitive price unless they can make credible commitments to buyers that the supply of the
good will not be unexpectedly increased in the future and no capital loss w ill be imposed on
current buyers. He suggested several ways in which the landowner can avoid this situation
and charge a monopoly price. The method of interest here is for the landowner to lease the
land for relatively short periods of time and then it w ill be easier for him to assure lessees that
no increase in supply w ill occur.
Ground Lease System and Monopoly
For the ground lease system, monopoly should not be a big problem as long as
ground leases do not lead to concentration o f land ownership in a large scale. But w ill the
ground lease system lead to a concentration of land ownership? As my theoretical analysis
shows, the efficiency o f the ground lease system comes from inter-community competition,
as well as other transaction cost efficiency properties. People's mobility and inter
community competition in the provision o f collective goods are important distinctions
between the modem ground lease system and the manor system in history. The efficiency o f
the manor system comes from exactly the opposite, i.e., the absence o f mobility and
commodity markets (North and Thomas, 1971). Collective goods only consist of justice and
security, on which there might be a slight sense o f competition between lords. Modem
ground lease systems are built on high mobility and the competition on providing collective
goods. If the ground lease system leads to concentration o f land ownership in a large scale,
then this important efficiency gain will lose and other transaction costs, such as governance
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costs and incentive alignment, will rise. In the long run. this kind o f large-scale ground lease
system is doomed to fail.
However, this may not be such a clear-cut issue. Monopoly is always an issue o f
degree. Since real estate is highly heterogeneous, differentiation between properties can
make the situation close to monopoly. But then there is no problem o f extra supply because
most land can not be easily divided without changing its quality. The supplier o f the property
can consequently charge the monopoly price without resorting to leasing or any other special
contractual arrangements. So leasing in general seems not to be naturally related to
monopoly. Traditional arguments against ground leases reflect responses toward complex
socio-economic situations instead of a pure form of ground lease itself.
A further issue that complicated the problem is that the property may not be as
durable as physical land per se. Coase (1972) argued that the production o f a less durable
good is very similar to a policy of leasing in that consumers do not need to fear an increase in
supply and a higher price can be charged. Although land is generally regarded as a durable
good, it is not completely durable as usually thought. Even for the private good embedded in
physical land, external depreciation and economic obsoleteness affect its value for use. On
the one hand, the collective goods bundled with the private good are much less durable. In
the extreme case, they can even be changing according to the terms o f politicians in
government. In this sense, collective goods result in less durability o f property and allow the
provider to charge a higher price if he/she has the monopoly. But on the other hand,
collective goods are more homogeneous and can be easily reproduced at other time and
places. The possibility o f monopoly is reduced because of this offsetting factor.
Nevertheless, if the following conditions are satisfied, then to some extent the landowner
does have monopoly and can charge a higher price without resorting to leasing. (1)
Government monopolizes the supply o f collective goods and thus the durability o f collective
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goods is limited; (2) or local governments do not have a strong incentive to "reproduce" the
highly demanded bundle o f collective goods; (3) the landowner can effectively differentiate
the property; (4) and some other land use regulations, such as zoning, can successfully
constrain the supply o f land. If these conditions are satisfied, some degree o f monopoly may
indeed exist no matter the land is owned or leased. So it is easy to see that a ground lease is
not a source for inefficiency in monopoly pricing, but rather that some other institutional
factors may result in monopoly.
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6 6
CHAPTER 7
CONCLUSION
Hayek (1988) stated that many institutions evolve as a result of the unintended
consequences o f human action. As they evolve, those that are less effective tend to be
eliminated. From a theoretical and institutional perspective. I analyze the ground lease based
land use system in order to reveal its efficiency properties in the urban context. However it
should not be taken for granted that any conscious design or ’social engineering' can reach
the most efficient solution. As demonstrated by the previous chapters, many institutional
arrangements are the tradeoffs among various considerations. Any efficiency arguments
ultimately depend on the decentralized knowledge about the circumstances o f time and place.
In Foldvary's (1995) work he demonstrated that many so-called public goods are
actually territorial collective goods. For them, free rider and exclusion problems can be
eliminated by the contractual provision of those goods. However, he did not pay much
attention to the fact that for land the private good and the territorial collective goods are
actually bundled together. I distinguish the bundled consumption o f territorial collective
goods from the bundling of their provisions. Then the central question is when the
consumer's "home bundling" becomes more efficient than bundling by market organizations.
On the other hand, even in the presence of'market failure' the provision of collective goods
by government through a political process is inefficient. The vote-by-head process is
inefficient relative to the vote-by-property process. I submit that the concept o f public good
is endogenous o f institutions and property rights and the real reason for "market failure” is
the belief in particular institutions and property rights. Even the decentralized model o f local
governments, the Tiebout Model, could not lead to efficient provision of local services due to
the landowners’ ex post immobility. This fundamental transformation of the relationship
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between the consumer and the provider o f the collective goods results in asymmetry and
inefficiency, which ultimately lead to various forms o f property rights and institutions to
overcome the problem.
The ground lease system is shown to be efficient in the provision o f collective goods
by internalizing the problem and making consumers footloose. From the transaction cost
perspective, its basic merits include (1) the integration o f landowner and the provider o f
collective goods, i.e.. the alignment o f asset specificity and governance structure. (2)
relatively little loss in the incentive intensity', (3) demand revelation through market price. (4)
footloose tenants, and (5) inter-community competition. I submit that the ground lease
system is the most efficient in providing territorial collective goods, as compared with
Samueison's model, the Tiebout model, etc. But since the private good, land is always
consumed together with collective goods, I argue that tradeoffs are necessary to reconcile the
two layers o f'‘institutional spectrums". This is the reason for various hybrid forms o f
institutions and property rights.
Following MacCallum’s question (1998) on residential and commercial real estate. I
analyze the growth o f CIDs in residential real estate, which is a hybrid form of government
and firm. CIDs have certain efficiency properties from the transaction cost perspective, such
as the integration o f landowner and the provider, but it is less efficient than the ground lease
system in terms o f providing collective goods. The justification o f CIDs lies in the analysis
o f property rights. I argue that the measurement problem for collective goods cannot
disappear at the ex post stage while for private goods only ex ante measurement problems
exist. For Austerian collective goods (1977), the bundling problem can be solved by
allowing people to own simultaneously more than one physical good. But for territorial
collective goods, this solution becomes infeasible and a complex form o f property rights
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becomes necessary to compromise the requirements from the private good and the collective
goods.
1 argue that a long-term lease is efficient for commercial real estate since it is easy to
monitor the input and the output. Even if there remains a measurement problem, a share
contract is enough to minimize measurement costs. The benefits from specialization are too
big to allow for sole ownership. But for residential real estate, the individual consumption
process greatly complicates the measurement difficulty and information asymmetry. Sole
ownership becomes an efficient choice. CIDs meet this requirement while enhancing the
efficiency in providing collective goods. It preserves the private ownership of land while
trying to provide collective goods efficiently through a hybrid form o f governance structure.
It is a perfect example of the combination o f ex ante ownership and ex post governance
structures.
In conclusion, the ground lease based land use system is most efficient in providing
territorial collective goods. However, because of the bundled consumption of private good
and collective goods, two offsetting issues limit its adoption in the real world. First, ground
lease system involves contracting costs. Second, control over the private use of land is still
important for people because it may be too costly and impossible for them to specify the
various uses. Hence, depending on people's preferences and purposes, many different forms
of property rights emerge to reconcile the control for private good and that for collective
goods.
There are several issues that may merit further research. First, throughout the thesis
the importance o f consumers' preferences has been emphasized although no elaboration is
made. Since the private good and the collective goods are bundled together, it is expected
that people's changing preferences have important effects on the form o f property rights and
institutions. Fischel (1995) stressed the role of Mand at peace' versus 'land at risk’ in the rise
69
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of zoning. It should not then be surprising that property rights are endogenous to people's
preferences.
Second, the development o f technology and human knowledge will have enormous
impact on institutions and property rights. The manorial system was an efficient institutional
response to the technology and other socio-economic factors at the time (North and Thomas.
1971). It was characterized by low mobility between manors due to underdeveloped
transportation technology. Today's ground lease systems and CIDs depend on modem
transportation technology. Similarly, the future development o f technology and human
societies w ill determine the trend in the evolution o f property rights and institutions.
Third, for territorial collective goods it is assumed that their territories are the same as
the ground lease system. In other words, we only discussed those collective goods that can
be provided within the spatial territory o f ground lease. It should be obvious that there are
many levels o f collective goods, from national defense to fire stations, and scale economy is
an important factor in determining the spatial scale of these goods. Therefore, we need to
analyze how transaction costs and production costs compromise at various spatial levels and
what are the institutional implications. This is exactly what Williamson meant when he
argued that "the object is not to economize on transaction costs but to economize in both
transaction and neoclassical production cost respects. Whether transaction cost economies
are realized at the expense of scale economies or scope economies thus needs to be assessed"
(1985, p. 61). A model incorporating the different levels o f collective goods may ultimately
lead to a hierarchical structure o f property rights and institutions.
The fourth issue is related to the flexibility-efflciency tradeoff and path-dependency.
In my analysis o f commercial and residential real estate. I seldom mention the impact o f
previous forms o f property rights and institutions. In many cases a particular form o f
property rights and institutions may not be efficient in terms o f transaction costs but very
70
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flexible and adaptable. Path-dependency problem is closely related. Many forms o f property
rights and institutions may be the result o f the evolution history o f the particular economic
process. In this sense, an analysis embedded in historic studies w ill be important for our
understanding o f the ground lease system and CIDs.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
71
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Asset Metadata

Creator Deng, Feng (author)

Core Title Economic analysis of ground lease-based land use system

School Graduate School

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag economics, general,Economics, Theory,OAI-PMH Harvest,Urban and Regional Planning

Language English

Contributor Digitized by ProQuest (provenance)

Advisor Gordon, Peter (committee chair), Nugent, Jeffrey B. (committee member), Richardson, Harry W. (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-31789

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