Free riders, holdouts, and public use: a tale of two externalities

Abstract

Free riders and holdouts are market failures that potentially impede the completion of otherwise beneficial transactions. The key difference is that the free rider problem is a demand side externality that requires taxation to compel payment for a public good, while the holdout problem is a supply side externality that requires eminent domain to force the sale of land for large scale projects. This paper highlights that distinction between these two problems and uses the resulting insights to clarify the meaning of the public use requirement of the Fifth Amendment takings clause. Journal of Economic Literature Classification: H41, K11

The Problem with the Holdout Problem

“…That is, when sellers are strategic holdouts, the developer knows he will acquire the properties through eminent domain, but when sellers are not strategic holdouts the developer knows he must acquire the properties through market exchange or not at all. On the other hand, if the regulator chooses "non-holdouts too" then it may be rational for the developer 10 We follow Miceli (2011) in assuming that the regulator can distinguish between homeowners who holdout for strategic versus sincere reasons. A "strategic holdout" is a property seller who is willing to accept the developer's price yet holds out in order to redistribute more of the bargaining surplus from the developer to the homeowner.…”

“…This conditional justification raises the question of how best to arrange institutional constraints in order to promote the efficient use of eminent domain. Miceli (2011) argues that the Kelo court arrived at the efficient legal rule, albeit for the incorrect reason. On the contrary, in light of our analysis, the Kelo ruling should be viewed as inefficient insofar as regulators use their discretionary 13 Much of James M. Buchanan's work sought to dismantle the implicit "benevolent despot" assumption that ran through most standard models in neoclassical public finance.…”

“…A recent strand of the literature had identified the holdout problem (not the collective benefits of economic development) as the appropriate market failure argument that justifies eminent domain. For example, Miceli (2011) models economic development as a collective consumption good that is less than efficiently produced because of free riders. Even though the courts (most notably the U.S. Supreme Court in Kelo vs. City of New London 1 ) tend to focus on free riding as the source of market failure, the policy that free riding would justify is taxation -not taking of property through eminent domain.…”

“…Even though the courts (most notably the U.S. Supreme Court in Kelo vs. City of New London 1 ) tend to focus on free riding as the source of market failure, the policy that free riding would justify is taxation -not taking of property through eminent domain. Instead, Miceli (2011) shows that holdouts impose a supply-side externality with the direct implication that governments can correct for allocative inefficiency by exercising powers of eminent domain. Concomitantly, this same strand of literature also clarifies the source of inefficiency that holdouts create.…”

“…This article approximates an answer to that question by presenting comparative statics on the inefficiencies of holdout relative to the inefficiencies of granting discretionary eminent domain powers to potentially opportunistic governments. We draw directly on the sequential bargaining model of Miceli (2011) and extend that model to incorporate the effects of discretionary eminent domain on the regulator's and the developer's incentive structure, including their associated efficiency effects. Ultimately any social welfare-maximizing legislature will grant discretion if and only if the social costs of holdout exceed the social costs of discretionary powers.…”