Model

x investment by landowner
Simple Model of Taking V(x) value of the land (to the landowner),
where V’ > 0, V” < 0
y the probability of a taking, or the fraction of
Assume that the government decision is exogenous. the land taken, assume y = 0.1 (that is, 10%)
B(y) benefit of the land for public use,
Let B denote B(y = 0.1)
C(x) compensation paid by the government to the
landowner in case of taking

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Timing of the model Timing of the model

landowner government court

landowner government court
---------l----------------l------------------l--------- > time ---------l----------------l------------------l--------- > time
x y dispute
resolution x y dispute
resolution
(1) Taking, or
(2) Regulation (1) Taking, or
(2) Regulation

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Analysis overview Efficient outcome

• Efficient outcome (x*) maximize SW ≡ B + 0.9 x V(x) + 0.1 x 0 − x
• The society tries to maximize social welfare. = B + 0.9V(x) − x
• Equilibrium outcome
• The landowner tries to maximize her own expected payoff. The relevant first-order conditions are

• The court determines compensation according to property

law.
0.9V′(x*) − 1 = 0 (8.1)

The first term in (8.1) is marginal benefit, while the

second term is marginal cost.

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 Equilibrium outcome Analysis: When can the equilibrium be efficient?

The landowner chooses x to Compare two first-order conditions

maximize P = 0.9V(x) + 0.1C(x) − x
FOC: 0.9V′(xl) + 0.1C′(xl) − 1 = 0.
The first two terms in (8.3) are expected marginal
benefit, while the third term is marginal cost.
0.9V′(x*) − 1 = 0 (8.1)
0.9V′(xl) + 0.1C′(xl) − 1 = 0. (8.3)
(8.3)
• C′=0 is necessary for the landowner to invest efficiently;
compensation must be lump sum to ensure that x l=x*.
• If C′ > 0, it leads to xl > x* -- over-investment.
• No compensation (C(x)=0 for all x) is efficient, although
any lump sum rule is consistent with efficiency.
• This is an example of the paradox of compensation.

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Analysis: When can the equilibrium be efficient? Remarks

Compare two objective functions:
• So far, we did our analysis by assuming y = 0.1.
The society maximizes B + 0.9V(x) − x The above analysis would be valid for any value of y
(for efficient outcome) where 0 < y ≤ 1.

The landowner maximizes 0.9V(x) + 0.1C(x) − x

• Note that we did not calculate derivatives by using calculus.
For our results, we did not need to use a specific function of
V(x). In other words, out analysis is applicable for all V(x).
• If C(x) = 0 (that is, no compensation), then both the society
and the landowner maximize the same objective function.
Thus, the equilibrium choice of x will be efficient.

• In general, C′=0 is necessary for the landowner to invest

efficiently; compensation must be independent of x.

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Comments on math requirement

• I will try to minimize use of calculus and mathematics in this
course as much as possible.

• In the exam, I plan not to test whether students can use

calculus to differentiate a general function.

• The idea of derivatives is very important as it is related to

marginal benefit and marginal cost concepts.

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