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The Economics of Kelo:

The basic economic problem of eminent domain is the trade-off between strategic holdouts on one hand and sincere subjective value on the other. The nature of a "property" right is that it gives a holdout power to anyone who holds it--I don't have to sell you my car or my autographed picture of Franco Harris's Immaculate Reception. And you can't have the government take them, even if you promise to pay compensation, but can acquire them only if I consent to what you give me in exchange. In so doing, we protect my subjective value in the good--i.e., the value that I put on Franco (especially because my wife gave me the picture as a Tenth Anniversay gift) is much higher than the market value of my Franco picture. So, in order to protect my subjective value, I am given a property right which permits to refuse to sell it--even for "fair market value." I have a holdout power, but it is not a problem, because we assume that the reason I refuse to sell is because I place a higher value on Franco than the market price.

This "holdout" power potentially becomes a problem in a case such as Kelo, where the buyer needs to assemble several pieces of land to build a building. Any individual may decide to hold out to try to extract a larger share of the surplus associated with the higher economic value from the transaction.

The problem is that in theory, in any given situation when someone refuses to sell we can't tell whether it is because of strategic holdout or subjective value. If we knew this, then we could get rid of market transactions in general, and move to a system of central planning where the planning czar just assigned various goods to their highest valued user. But that obviously won't work. But there are better, and worse, ways of dealing with this problem. The overall facts of Kelo illustrate one of the worse ways of dealing with it, and why we need to have a real "public use" doctrine that doesn't permit taking from A to give to B.

Suppose I make you an offer for the "fair market value" of your house and you refuse. So I go to the City Council and tell them that I will make an enforceable promise to pay one dollar more in taxes than you pay on your house if they would just condemn it and give it to me. And if they evicted you, they wouldn't pay your moving expenses or disruption expenses associated with finding a new place to live. Now imagine you grew up in the house, lived there for sixty years, raised your kids there and hoped to die there.

Under those facts, would your unwillingness to accept my offer evidence that you are just being a strategic holdout? Certainly it seems plausible in that situation that the refusal of you to sell to me is efficient, in that you have high subjective value. So if I get the house and only have to pay fair market value through an eminent domaian proceeding, that result is economically inefficient because the property is not held by the highest-valued user. But in addition, we know that the strategic holdout threat isn't meaningful here. Why? Because at the time I refuse to sell, I have no strategic holdout power--if I don't sell, you can go down the street and buy another house. So we can infer from my behavior that my refusal to sell is the result of subjective value, not strategic holdout.

And all of this analysis excludes that the wealth loss here is not just the possibility of an efficiency loss by ignoring subjective value and the undercompensation problem (the so-called "Harberger Triangle" dead-weight loss), but also the Tullock Box of the rent-seeking expenses you and I both burn up trying to effect this political transfer rather than a voluntary market transfer (the real costs of rent-seeking, of course). When we replace a positive-sum voluntary market exchange with a political exchange, both parties have an incentive to "lawyer-up" and engage in various rent-seeking expenditures to try to get the result they desire. So this is the primary reason why the "public use" requirement is (or should be) a gatekeeper to make sure that I am not taking your house just because I want to end-run a consensual market exchange that I might find inconvenient or too expensive. None of the other restrictions on takings perform this function of properly channeling private transactions through the market where they belong, and where subjective value can be protected (and thus efficiency can be protected as well). Moreover, this is a threat that is unique to the private takings situation in Kelo, because with respect to a traditional public purpose taking, the undercompensation problem remains, but the strategic temptation to end-run the market to try to get the property for less than the seller's subjective value will not, because governement actors don't benefit as directly as Pfizer does.

Second, focusing on the holdout problem in the Kelo context is to focus on the wrong issue. The scenario here is different from when a government wants to build a school or post office, traditional public use purposes. Schools and post offices have to go in a particular geographic area (that's why they are being built), and thus strategic bargaining may be plausible because it is similar to a bilateral monopoly situation. The small group of landowners in the relevant area can act strategically and try to extract a high price for its sale.

In Kelo, however, there is no obvious holdout power because Pfizer could put its building in any city in America. So its not like a neighborhood school, road, or post office. In Kelo, the holdout power is created artificially by the city's desire to give Pfizer a sweetheart deal to bring it to town.

So ex ante, there is no viable holdout power in this situation because there are an infinite number of close substitute sites for the building. The building is going to be built somewhere, the only question is what city--New London, Hartford, Bridgeport, Boston, New York, Chicago, etc. The artificial scarcity that says the building has to be built in New London was created by the city's other subsidies to attract Pfizer to town (the obscenely low rent, etc.).

So if one is truly concerned about the holdout power problem, then the correct solution is to require the city to eliminate the artificial scarcity that "requires" the building to be built in New London rather than some other city, the same way that a new school would have to be built in New London. If we allow both the subsidies and the Taking for the benefit of the private party, we are allowing the distribution tail of what city the Pfizer headquarters will be built to wag the efficiency dog of whether the homeowner is holding out versus having subjective value. Instead, we want to have the parties bargain ex ante before they finally select the city--i.e., choose the city and the plot of land at the same time--not bargain ex post after the city is selected. Forcing an ex ante bargain when there are still many substitutes for the proposed site would eliminate the holdout problem and allow us to determine the extent of parties' subjective value, because the negotiations would be conducted against the backdrop of a competitive market, rather than a bilateral monopoly. The bilateral monopoly is thrust upon the city in the road or post office scenario; it is freely-chosen in the Kelo situation.

Instead, the ruling in Kelo enables the worst possible economic outcome--it permits cities to create artificial scarcity just to get a larger piece of a stable-sized pie (getting Pfizer to New London rather than Hartford), while then permitting cities on the back end to take land from private landowners who may or may not be losing subjective value and being undercompensated in the process.

And the incentive effect of Kelo is obvious--it now enables corporations to extract both subsidies and takings as the price for locating in city A rather than city B.

To further understand the second point, recall the Alaska Packers case from first-year Contracts (any of my former Contracts students out there reading this?). In that case, the shipowner and the crew bargained for wages while on the dock in San Francisco, then when the crew got to Alaska they demanded to renegotiate. The renegotiation may have been either sincere or strategic, its not clear. What we do know, however, was that the crew's bluff was real, because the captain could not turn the boat back around and cruise back to San Francisco to get a new crew without losing the seasonal catch. The Court refused to enforce the modified contract.

This is the correct answer, even though we can't tell for sure whether the subsequent renegotiation demand was sincere or strategic. The reason it is correct is because we want to make the fishermen and the shipowner in Alaska Packers have the right incentives to strike their bargain while they are all still on the dock in San Francisco. At that time there are still close market substitutes, not when they are on the boat to Alaska and it is now a bilateral monopoly situation. So we want to have a rule that enforce the first deal, not the second.

Same analysis applies here--the private taking only comes about because of the contrived artificial scarcity created by the ridiculous government subsidies to lure Pfizer to New London rather than some other city. There is no efficiency gain from providing public goods (as with a road, school, or post office). So rather than rewarding the city for creating an artificial scarcity, which then makes it vulnerable to a hold-out power, it would make more sense to deny them the right to condemn ex post, thereby encouraging more efficient arms'-length bargaining ex ante.

Joel B.:
Great post, I agree with you, and really appreciate how you laid out that it is New London itself that is creating the problem of holdouts by enticing Pfizer to their city from the start, that they should turn around and seize private property after creating the artificial scarcity is especially appalling. As is the fact, that they now supposedly have the power.

That being said, just because the Supreme Court says something is constitutional doesn't make it so, if it truly is not. It just means we can't go to them for a remedy.
6.30.2005 6:01pm
Grant Gould (mail):
I agree with your reasoning entirely, but must take issue with your terminology. You distinguish between the high subjective value and the "fair market value" -- but these are one and the same: The current owner is a part of the market, too, and his valuation as much a floor on the fair market value as any other market participant. If you subjectively value your picture at $x, the fair market value cannot be less than $x, because you are a member of the market.

This is one of the major problems with takings: The computation of "fair market value" is done in a bloodless manner, excluding from the "fair market" any actual market participants and substituting instead legislative or judicial imaginings of possible market participants.
6.30.2005 6:14pm
Splunge (mail):
An interesting post. It's a shame Mr. Zywicki did not additionally emphasize that any distinction between "subjective value" and "fair market value" is as logically shaky as a distinction between what a word "really" means and what everyone uses it to mean.

It seems to me the only reasonable and practical definition of "fair market value," in the absence of direct communication from God on the topic, is the community average of individual "subjective values." That is, "fair market value" would seem to be strictly an empirical fact, only determinable by measurement in a free market. I can't see how any theoretical argument at all is capable of supplying it, or even hinting at it.

Hence I think there is no way even in principle to distinguish between "fair market value" and the collective average of "subjective value."

One can, post facto, after the market average has been determined, say that person X's value of a given property is higher or lower than the average. But it would be irrational to therefore argue that X's value should be discarded or otherwise regarded as exceptional, for the simple reason that the market average contains and must contain this valuation.

For example, if X's value of the property were discarded as being "out of step" with the market, then of course the market average would decrease, and Y's value -- the next highest -- would become "out of step" in turn, need to be removed from the average, and so forth, ad absurdum, until there is no data left in the average, or some meaningless and arbitrary stopping point is chosen. That is, it's mathematically inconsistent to argue that an individual datum is "out of step" with an average constructed from data that includes this datum.
6.30.2005 6:25pm
Buck Turgidson (mail):
There is one more glitch that is between the strategic and subjective hold out. That's the one that makes the case so difficult to accept. Let me construct a hypothetical.

I buy a strip mall for $10 mil. Due to an economic downturn five years later, half the businesses in the mall close down and I am unable to replace them. Although the land cost remains nearly the same, the fair market value at that moment might be a mere $7.5 mil. I anticipate that as the economy improves, the cost of the property will recover and expect to sell it in another 5 years for, say, $12 mil. Meanwhile, there is no insentive to sell as a part of the property still collects rent and the fair market value is not sufficient to recoup the costs of acquisition and upkeep.

The county decides that strip malls are a thing of the past and, therefore, constitute a blight. They plan to collect the property for its current value ($7.5 mil) and turn it over to another developer who wants to put a mega-mall in its place. Since I cannot recoup an anticipated value--even if this value is quite realistic, perhaps even conservative--I am going to lose my shirt on the deal.

In this case, my hold out is not entirely strategic--I am not looking to hold the developer over the barrel, but to recoup the costs. Nor is it entirely subjective--my costs are quite real and the economics of the situation perfectly reasonable (even though the description is clearly an oversimplification of the situation).

Think of this differently. Suppose you buy a car that turns out to be a lemon. The seller wants to "keep you happy" so he offers to buy the car back for its fair market value. Not for the value that you paid for it, but for the value that it has as a lemon. In common parlance this would be known as a swindle.
6.30.2005 6:35pm
SKlein:
If I understand Mr. Zywicki's "solution", it is that there should be multiple conditional negotiations (Many cities engaged in many "If Pfizer decides to build in our town, we will pay you X" negotiations). Do not the transaction costs dwarf (by orders of magnitude) any possible efficiency/fairness gains? And apart from transaction costs, are there not a significant group of land owners that are uninterested and unwilling to participate in those sort of conditional negotiations.
6.30.2005 6:42pm
anonner (mail):
You raised the issue early on and then dodged it completely. Just admit it. It should have been ruled incomplete.
6.30.2005 7:20pm
Moral Hazard (mail):
One thing to remember is that the fifth ammendment references "just compensation" not "fair market value." Admittedly "just compensation" is a subjective judgement, but in my opinion it is unjust to require someone to change their place of residence or business with no compensation for moving expenses or personal valuations above what others would consider "fair market value."

In the case of transfers between private parties, I don't understand why the government would need to use eminent domain at all.

If we assume the government believes there would be a public benefit if prospective owner A held a piece of property instead of current owner B, why not offer prospective owner A some portion of that value in monetary terms as a subsidy to the purchase? If B accepts, then everybody wins. If the government offers to subsidize the full value of the benefit to A, and B still refuses to sell, then B obviously places too high a value on the propert for there to be a net benefit.

Am I missing something, or is the entire idea of using eminent domain to transfer property between private parties just a method of extracting value from the current owner?
6.30.2005 7:27pm
Cory (mail):
"If I understand Mr. Zywicki's "solution", it is that there should be multiple conditional negotiations (Many cities engaged in many "If Pfizer decides to build in our town, we will pay you X" negotiations)."

I don't think you read him correctly. He says this:
"Instead, we want to have the parties bargain ex ante before they finally select the city--i.e., choose the city and the plot of land at the same time--not bargain ex post after the city is selected."

The parties in question here are the potential developer and the landowners. In other words, Pfizer goes around, finds several possible plots of land, and bargains with the owners directly, informing them up front that if someone else in another city sells first, the deal is off. There is no need for the city to be involved at all, beyond having favorable zoning regulations.

Zywicki does not explain why the holdout will not be a problem, but it is fairly obvious. If the developer tells the potential sellers that they are bargaining in several places simultaineously, a potential strategic holdout has an incentive to undercut the potential holdouts at the other places, and it is likely that at least on of them would sell at a fairly reasonable price. If the buyer offers at slightly above the market price, a holdout has a strong incentive to take it, rather than risk getting nothing at all.
6.30.2005 7:46pm
lucia (mail) (www):
Excellent article.

I want to comment on something Splunge posted:
It seems to me the only reasonable and practical definition of "fair market value," in the absence of direct communication from God on the topic, is the community average of individual "subjective values."

This cannot be. The fair market value is certainly not equal to the the average of individual subjective values. If they are equal, then auctions would consistently result in over-pricing. Many luxury items would also be overpriced. After all, I, and many of my friends, are unwilling to spend $400 on even the most tasty bottle of wine that might exist. Consequently the "average subjective value" for a rare bottle of wine is certainly much less than its probable sale price.

That said, I would be extremely pleased if someone would determine the "average" of all subjective values for a rare and tasty bottle of wine, and permit me to buy for that price. Afterwards, I will quietly sell it to one of the people who was willing to pay much more than average.
6.30.2005 7:56pm
Steve:
Just so we're clear, the property at issue in Kelo wasn't being developed by Pfizer. It included housing, shopping, office space, parks, and the like, in order to take advantage of a nearby research facility being separately developed by Pfizer. This is quite a bit different, and considerably more difficult to negotiate, than a use of eminent domain to help Pfizer build a plant.
6.30.2005 8:13pm
Splunge (mail):
Lucia, you are forgetting that a free market is an auction that happens over and over again. It's true the first and most eager buyer pays more than the average for an item, but the next buyer will not, and so the price falls.

Ultimately, in order for the supply to equal the demand, the average price paid for a good must equal the average utility ("subjective value") it delivers to buyers. I mean, this is basic economics, no? It would be psychologically bizarre if the average buyer paid more for an item than it was personally worth to him, or if the average seller accepted less for an item than it was personally worth to him, would it not? We must presume that people are rational.
6.30.2005 8:21pm
lucia (mail) (www):
No, I am not forgetting the free market is an auction that happens again and again. You've reworded, and now seem to say "average subjective value of the ultimate buyer". At auction, that buyer is the highest bidder during that particular test of the marketplace. The price excluded the subjective value held by all the people who did not buy and would not pay the highest price although they might buy the item for less.

If that is what you initially meant by, that's fair enough. It just didn't happen to be what I understood you to be saying, particularly in the context of the later paragraphs.
6.30.2005 8:34pm
TFox (www):
I admit that I haven't been following this, but could someone explain why the ownership structure is so important? Eg., schools, roads, and post offices, normally public, are okay, but housing, shopping, office space, and parks, often private, are not? But schools, roads, and post offices could all be privately owned and operated, just as parks and offices could be public. Or is it the lack of public use? But is there no possible public interest in shopping or living in the new development, or the possibility of getting a job at Pfizer? I guess I'm having a hard time distinguishing the artificial creation of holdout power from landing Pfizer (who could, after all, have gone somewhere else) vs. the artificial creation of holdout power in building a road from A to B (after all, the people in A could go somewhere else too). There's something I'm missing here...
6.30.2005 8:52pm
Mark Draughn (mail) (www):
So how does this work out when a developer wants to buy an entire block of homes? There's one buyer and several sellers, but the buyer can't get his surplus from the deal unless every seller agrees to sell. The last guy to sell gets to hold out and get extra surplus. The buyer could protect himself by conditioning the deal on all sellers agreeing. Then one of the sellers could hold out against the others, demanding payments. It seems like there would be some inefficient rent seeking, but I'm too confused to figure it out myself.
6.30.2005 9:20pm
Bill (mail):
Todd's economic analysis here is great. But I am reminded of his previous reluctance to embrace social science in considering whether Ten Commandment displays or litigation about them is more divisive. [I wrote a long post under his original one there.]

Todd: You call Breyer's analysis "second rate". Is there any other relevant difference (besides quality of analysis) between your Kelo analysis and the social scientific inquiry into divisiveness that you forswore? I can think of two or three that I mentioned in the other post. But none of them really seem decisive to me.
6.30.2005 9:29pm
Slocum (mail):
Well, I think there's a problem with the analysis because there's a problem with the facts. My understanding is the Kelo case did not address land for Pfizer to build its new corporate center but rather an ancillary development that the city wanted to do because Pfizer was coming to town. ED was not done for Pfizer's benefit, it was done to take advantage of development opportunities that the new Pfizer center made feasible. Which makes hash of this:

So ex ante, there is no viable holdout power in this situation because there are an infinite number of close substitute sites for the building. The building is going to be built somewhere, the only question is what city--New London, Hartford, Bridgeport, Boston, New York, Chicago, etc.


The city of New London, of course, wanted the development in New London, obviously, and what they had in mind (a conference hotel, marinas, a 'riverwalk' and a bunch of new, high-priced waterfront homes) couldn't go just anywhere in town -- it had to go on the waterfront, and it had to go near the new Pfizer building for the 'synergies' to make any sense. So the idea that there was the opportunity to negotiate with a variety of property owner in various locales to get around the holdout problem seems not well-supported.

However, it seems it would have been possible for the developers to adjust the plan based on the properties they were and were not able to obtain--it is far from clear that most of the project couldn't have been executed while leaving a few holdouts. Perhaps ED could have been used for only the public riverside promenade (a reasonable use of ED), and the project could have been build around a couple of scattered old homes. I suspect had such an approach been taken, the developers ultimately could have reached reasonable agreements with all of the existing homeowners because to do the rest of the development around the holdouts would mean a fundamental change to the neighborhood. What's the value of living in the same house as you have for 60 years if you're suddenly surrounded not by a quiet neighborhood of modest houses but by a conference hotel, shopping mall, public promenade, etc?
6.30.2005 10:20pm
NaG (mail):
It seems to me that the ultimate effect of Kelo will be to depress property values, simply because "just compensation" can now be a price that any owner may be forced to accept. If you are a developer looking to develop several parcels of land at once, the owners of each parcel should be able to gain from your enhanced valuation of the parcels as a unified whole. But now a developer can go to a holdout owner and say, "You know, if you don't take my offer, I'll just have the local municipal board force you to sell it to them, and they'll give it to me for the same price." Now the developers don't have to offer prices as high as they otherwise would, and that brings down property values overall.
7.1.2005 10:13am
Zywicki (mail):
As always, numerous superb comments. I primarily want to read what you all are saying, so I will just add a small clarifying point here, and a longer discussion of Bill's interesting point on the main blog.

The difference between subjective value and fair market value is that fair market value is a measurement of what the marginal buyer and seller in a given market would pay for a given good or piece of land. If subjective value is present, this means that the poential seller places a value on the property above the fair market value. So, say my wife paid $100 for the Franco picture (one of, say, 50 on the market). I would only sell the picture for, say, $400. So my subjective value ($400) is higher than the fair market value ($100), so if the "buyer" values it for less than $400, the transfer is economically inefficient.
7.1.2005 10:54am
JF (mail):
One quick note to Mr. Turgidson: Not if markets are efficient... the expected future price of the strip mall will be impounded (less the discount rate) into the current value of the strip mall.
7.1.2005 1:57pm
Cheburashka (mail):
I think that economic analysis is just plain wrong, for at least two reasons. First:

My understanding is the Kelo case did not address land for Pfizer to build its new corporate center but rather an ancillary development that the city wanted to do because Pfizer was coming to town. ED was not done for Pfizer's benefit, it was done to take advantage of development opportunities that the new Pfizer center made feasible.

True, but there's more - part of the value of this property, to its present owners is derived from the existing presence of Pfizer. If you haven't been to New London, you may have to trust me on this one; but-for Pfizer, there simply wouldn't be a town there for these people to shop in, drive through, or go to the movies in. Part of the value of this land was gained through externalities brought by the party largely responsible for the new taking - and internalization is an economic positive.

Second:

When we replace a positive-sum voluntary market exchange with a political exchange, both parties have an incentive to "lawyer-up" and engage in various rent-seeking expenditures to try to get the result they desire.

Absolutely true, but not followed to its conclusion.

Unless the subjective value of land to be taken generally exceeds the transactional cost of effecting a taking, then the fact that takings are a realistic possibility implies that land owners will be compensated at least partially, if not fully, for the subjective value of the property.
7.1.2005 2:14pm
Front Porch Philosopher (mail):
Just so I understand this.....

If I own a piece of art, or an antique, that has been in my family for generations, and some city wants to make it the centerpiece of a museum (public OR private) that will bring increased traffic, and thus revenue - to a dilapidated downtown, they can just TAKE it for whatever THEY say it's worth!?! And the only thing I can fight is the PRICE?

ANY property, not just real estate!?!
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