Albeit vast evidence suggests that strong property rights and limited transaction costs foster trade and innovation, their determinants and interaction are still poorly understood. To help tackle this issue, I provide a theory of the formation of transaction costs and the consequent selection of property rights incorporating into economics the key Calabresi and Melamed’s (1972) insight that incomplete property rights can be efficient when transaction costs impede valuable exchange/innovation and, thus, deliver large ex post misallocations. Consistent with this view, despite all legal systems punish theft and embezzlement and provide remedies for dispossessed owners, parties are allowed, whenever the obstacles to transactions are sizable, to take private property without the original owners’ consent and by possibly paying a predetermined compensation (Bouckaert and De Geest 1995). This is the case of a good faith buyer acquiring from an intermediary a good either stolen or embezzled from its original owner, a nonpaying tenant successfully avoiding eviction,^Footnote1 a state expropriating a citizen for private for-profit use, an agent lawfully breaching a contract, majority shareholders successfully extracting from a firm creditors’ and minority shareholders’ resources, a principal lawfully segmenting a market and a downstream firm exploiting an upstream party’s intellectual property through fiduciary duties and shop right provisions.

To analyze these and other cases of legalized direct and indirect—i.e., mediated by the state—private takings, I study the design of the property rights on either a good whose consensual transfer entails a transaction inefficiency or an upstream firm’s input whose random cost is nonverifiable and ex ante non-contractible. Following the “property rights” literature (Allen 2000),^Footnote2 I define the strength of the original owner’s property rights as the odds with which he receives back a good expropriated by the potential buyer and the legal protection of the upstream firm as his ex post bargaining power.^Footnote3 Both definitions are consistent with Alchian’s (1965) view that economic property rights are those of “individuals to the use of resources.” Departing from the property rights literature, I define transaction costs as “any impediments or costs of negotiating” (Calabresi and Melamed 1972), and I distinguish between trade barriers that are outside the control of transactors—e.g., financial frictions—and trade/innovation hurdles driven by either the market power, superior information or contractual advantage of some of them (see the Internet Appendix). I label the former as “exogenous” transaction costs and the latter as “endogenous” transaction costs.

Starting with the interplay among property rights, transaction costs and exchange, I build on Guerriero (2016a), and I evaluate a society equally split into homogeneous original owners and potential buyers having different valuations for the single good in the economy. The two groups are randomly matched by an intermediation technology allowing the potential buyers to obtain the good via either a consensual transfer entailing a transaction inefficiency or by expropriating it at a cost that, without loss of generality, I assume negligible. When transaction costs are exogenous, consensual transfers require that the potential buyers pay to the original owners their valuation plus a socially wasteful fee. Then, full protection of the original owners’ property implies that an expropriated good is always returned and some potential buyers with valuations higher than that of the original owners are inefficiently excluded from trade due to the transaction fee. Weaker property rights, instead, alleviate this misallocation by probabilistically allowing middle-valuation potential buyers to consume, but, contemporaneously, push low-valuation potential buyers to inefficiently expropriate their match. This trade-off between inefficient exclusion from trade and expropriation implies that property rights are optimally weakened when transaction costs are sizable and more so the larger are the impediments to negotiation. Intuitively, a rise in transaction costs has both the marginal effect of pushing some high-valuation potential buyers to expropriate the good and the infra-marginal effect of decreasing the social gains from consensual transfers. Being both effects welfare-decreasing, larger negotiation costs must also weaken the protection of property and, in turn, shrink the market, i.e., decrease the measure of consensual transfers.

Similar patterns prevail when transaction costs are endogenously determined by either the original owners’ market power or their privileged information. In the former case, the markup selected by the original owners is socially valuable as a transfer but entails an equal distortion in the potential buyers’ demand. Since a rise in the dispersion in the traders’ valuation increases the measure of matches on which a markup is commanded relative to the number of matches supporting expropriation, it also augments the markup itself and the demand distortion to the point of making incomplete property rights optimal. When it is the degree of asymmetry in information to inefficiently exclude middle-valuation potential buyers, a rise in the difference between their payoff and the original owners’ valuation endogenously worsens the lemons-type distortions and calls for a weaker protection of property.

Turning to the interplay among property rights, transaction costs and innovation, I build on Grossman and Hart (1986) and Guerriero and Pignataro (2021), and I consider heterogeneous projects each involving an upstream and a downstream firm. The former can either produce in-house via an “old” technology or adopt a “new”—more efficient—technology necessitating both parties’ investments. While both input costs and payoffs are nonverifiable and ex ante non-contractible, only the former are ex post contractible and only the upstream firms’ input cost is random and realized after he has committed his investment. The mix of contract incompleteness and the upstream firm’s uncertainty on his cost assures him an “appropriable quasi-rent” (Barzel 1994), which rises with the likelihood of a low cost realization, equals the specificity of the downstream firms’ input and distorts the extent of innovation if too large. As a consequence, a strong protection of the upstream party’s input excessively increases the expected appropriable quasi-rent, discouraging high-productivity downstream firms from innovating. When, instead, property rights are weak, low-productivity downstream parties inefficiently select the new technology. This trade-off between inefficient exclusion from innovation and expropriation entails that larger odds of a low innovation cost and, thus, a more severe contract incompleteness must undermine the upstream firms’ property rights and reduce the extent of in-house production.

Two obvious objections to the model reasoning are that some transactors have more political influence on institutional design and that weak property rights entail a disincentive effect. Crucially, the model testable predictions survive when I consider these possibilities, but two novel implications arise. First, property is protected too much in the most likely case in which those guiding institutional design are also initially holding economic value since these transactors prefer a too strong protection of their property. Second, property rights are optimally strengthened to incentivize original owners to either produce or invest.

To assess whether the correlations in the available data are consistent with the most innovative model implications, I analyze a panel of 139 countries spanning the 2006–2018 period. For this sample, the Executive Opinion Survey—EOS, hereafter—reports measures for the protection of the original owners’ and downstream firms’ personal, intellectual, and financial property as well as proxies for the severity of financial frictions, market power, lemons-type distortions and the specificity of the downstream parties’ input, which, as aforementioned, picks the severity of contract incompleteness. By combining information collected from the EOS and the Doing Business Project, moreover, I obtain a measure of the availability for firms of technological innovations, which I employ as proxy for less disperse traders’ valuations and larger odds of a low innovation cost. While the second interpretation is straightforward, the first one is consonant with recent firm-level evidence suggesting that a limited technological availability, and not more severe transaction costs, induces less-developed countries to organize themselves around economies marked by a larger dispersion in the firms’ productivity and, in turn, in the consumers’ valuation for final goods (Porzio 2018). Conditional on country and year fixed effects, OLS estimates reveal two key results coherent with the model. First, the protection of the original owners’ and downstream parties’ property is weaker where financial frictions, market power and lemons-type distortions are more severe and where the downstream firms’ input is less specific. Second, the availability of technological progress is negatively related to financial inefficiencies, market power and lemons-type distortions and positively linked to the specificity of the downstream parties’ input.

To gain more insights about causality without the presumption to prove it, I discuss in the Internet Appendix three extra results. First, my conclusions are similar when I either switch to an objective measure of property rights or consider different proxies for both exogenous and endogenous transaction costs. This pattern suggests that measurement error does not seem to be a major issue. Second, I also consider the other main determinants of property rights and transaction costs such as income, inclusiveness of political institutions, non-produced output, both external and internal conflicts and a culture of innovation. Including these observable factors together leaves the results almost intact as it does also considering the main determinants of either legal protection or transaction costs lead one year. The fact that these lead values are insignificant, moreover, excludes that the estimates are driven by reverse causation. Finally, I calculate that the influence of unobservables would need to be on average more than seven times stronger than the influence of all the observables that I consider to completely explain away the OLS estimates. Accordingly, it seems difficult to envision that unobserved heterogeneity is driving the empirical results.

This study provides and tests a first theory of endogenous market design clarifying how fundamental factors, such as the dispersion in the traders’ valuation and the odds of a lower innovation cost, shape the severity of the impediments to negotiation and, in turn, the protection of property. The strength of property rights determines, in turn, the limits between market and non-market activities. Hence, my paper is related to four strands of the literature on transaction costs and property rights. First, it is linked to several contributions showing that weak property rights can be optimal in an endowment economy (Kaplow and Shavell 1996; Jordan 2006; Bar-Gill and Persico 2016; Segal and Whinston 2016; Arruñada et al. 2019). As Guerriero (2016a), not only do I extend this result to production economies, but I also clarify how weak property rights can partially neutralize market frictions and failures [see also Boldrin and Levine (2013)]. Different from the present paper however, Guerriero (2016a) focuses on the link between the diversity in the potential buyers’ valuation and the legal protection of original owners, without characterizing theoretically the determinants and impact of contract incompleteness and empirically the determinants of transaction costs and their impact on property rights. Second, my study is also related to that of Guerriero and Pignataro (2021), who analyze the interplay among the intensity and specificity of the firms’ inputs, their property rights, and the ownership structure. Because of their focus on ex ante incentives, these Authors conclude that the strength of the upstream firms’ property rights not only falls with the specificity of the downstream parties’ input but also rises with the specificity of their own investment. Third, my analysis of negotiating costs is part of a body of research—still in its infancy—on endogenous transaction costs (Williamson 2010; Barry et al. 2014). None of these papers, however, has emphasized the roles of the dispersion in the traders’ valuation and/or the odds of innovation. Finally, Acemoglu and Johnson (2005) compare property rights protection with contract enforcement. Different from these Authors, I examine the determinants of the trade-off between these two institutional strategies created by the possibility of non-consensual transfers, and I emphasize that weak property rights are society’s response to sizable transaction costs (see also Aghion et al. (2010)).

The paper proceeds as follows. In Sect. 2, I show that the basic correlations in the available data are consistent with the main model implications. Next, I illustrate the main model in Sect. 3, and I evaluate its robustness to alternative assumptions in Sect. 4. Finally, I conclude in Sect. 5, and I gather proofs, tables, and figures in the Appendix.