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.