In his famous 1979 lecture, “Politics Without Romance,” James M. Buchanan briefly summarizes public choice theory and some of its implications. He puts special emphasis on viewing government as made up of individuals who respond to incentives in the decisions they make. This is contrary to the naive view of government that was implicitly assumed before public choice came along. That naive view would go something like this: 1. identify a market failure (defined as voluntary exchange deviating from the ideal of Pareto optimality); and 2. justify government intervention to correct that market failure. Buchanan calls this line of reasoning a “romantic” view of government, and he says it doesn’t hold up to even a little scrutiny.
It seems to be nothing more than simple and obvious wisdom to compare social institutions as they might be expected actually to operate rather than to compare romantic models of how such institutions might be hoped to operate.
Even so, the naive view presses on, as recent publications on the holdout problem demonstrate. The holdout problem arises when sellers of land (or other valuable resources) strategically choose not to sell, even though the would-be buyer offers a price that the seller would accept. Instead, the seller holds out for a higher price, and this might kill the deal or create delay costs. Strategic holdouts thereby prevent resources from flowing to more valued uses, which is termed inefficient in economics–that is, it’s a market failure. This line of argument is carefully developed in a 2011 paper in Public Choice, which promotes what Buchanan would call a romantic policy conclusion:
…the holdout problem arises in the presence of a supply-side externality and therefore justifies eminent domain (forced sale) to facilitate land assembly.
I have co-authored a new paper in response, titled “The Problem With the Holdout Problem” [free download on SSRN]. Here’s the upshot:
The problem with the holdout problem is this: it is strictly a prima facie argument for justifying eminent domain, ignoring the potential for inefficiencies that may emerge when political authorities are empowered to substitute for market exchange. This is an old argument, articulated clearly in Buchanan (1962) and as early as Arthur Pigou in 1920.
“In any [market failure], there is a prima facie case for public intervention. The case, however, cannot become more than a prima facie one, until we have considered the qualifications, which governmental agencies may be expected to possess for intervening advantageously. It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustment that economists in their studies can imagine. For we cannot expect that any public authority will attain, or will even whole-heartedly seek, that ideal. Such authorities are liable alike to ignorance, to sectional pressure and to personal corruption by private interest.” (Pigou 1920, Pt.II, Ch.XX, Sec.4)
In the context of recent sequential bargaining models that identify strategic holdout as the proper justification for eminent domain, it bears scrutinizing whether regulators would use the takings power to correct for holdout inefficiencies and nothing more. We can imagine a benevolent and omniscient regulator who would choose “holdouts only,” thereby dissuading developers from incurring socially wasteful rent-seeking costs, and thus achieving the uniquely efficient outcome in Figure 2. However, as Buchanan and Pigou separately suggest, there is insight to be gained by relaxing the benevolence assumption. In this paper we assume that the regulator is instrumentally rational and fully informed. We find that the unrestricted regulator can have an incentive to use eminent domain on non-holdouts, and developers will thereby have the incentive to rent seek. These political actions generate two forms of social costs; therefore, the holdout justification of eminent domain is conditional…
In other words, eminent domain is justified on efficiency grounds if and only if the social costs of holdout exceed the combined social costs of rent seeking by the developer and externalities created by the regulator when using eminent domain on non-holdouts.
Enjoy. Again and again…