Toward a Theory of Toward a Theory of Property RightsProperty Rights

Harold Demsetz, (1967) American Economic Review, 57 (May): 347-359

Group 1: Meredith, Barclay, Woo-je, & Kumar

Property Rights: IntroductionProperty Rights: IntroductionWhen a transaction is concluded in the marketplace, two bundles of property rights are exchanged

A bundle of rights is often attached to physical commodity or service

It is the economic value of the rights that determines the economic value of what is exchanged

Economist view a bundle of property rights as datum and ask for an explanation of forces determining price and number of units of a good to which these rights attach

Demsetz seeks to fashion some of the elements of an economic theory of property rights through concept and role, emergence, and coalescing

The Concept and Role of Property RightsThe Concept and Role of Property Rights

Property rights are an instrument of society and help man form those expectations which he can reasonably hold in his dealings with others

Expressed in Laws, Customs, and Mores of a society

Property rights convey the right to benefit or harm oneself or others and specify who must pay to modify the actions taken by persons. Close relationship between Property rights and Externalities

Example: Harming a competitor by producing superior products may be permitted, while shooting him may not.Example: A man may be permitted to benefit himself by shooting an intruder, but be prohibited from selling below a price floor.

The Concept and Role of Property RightsThe Concept and Role of Property Rights

Externalities External costs, external benefits, pecuniary and non-pecuniary externalities

No harmful or beneficial effect is external to the world

What converts a harmful or beneficial effect into an externality is the cost of bringing the effect to bear on the decisions of one or more of the interacting persons is too high to make it worthwhile INTERNALIZING

The Concept and Role of Property RightsThe Concept and Role of Property Rights

Internalizing refers to a process, usually a change in property rights that enables these effects to bear on all interacting persons

Primary function of property rights is that of guiding economic incentives to achieve a greater internalization of externalities

Condition necessary to make costs and benefits externalities is: Transaction costs in the rights between parties must exceed the gains from internalization

The Concept and Role of Property RightsThe Concept and Role of Property Rights

Example: Slave Labor

Might be thought that a firm that uses slave labor will not recognize all the costs of its activities

Not true if negotiations are permitted, for slaves can offer a payment of their freedom to the firm based on the expected return to them of being free men.

Cost of slavery is then internalized in the calculations of the firm.

The Concept and Role of Property RightsThe Concept and Role of Property Rights

Example : Military Draft

Taxpayer benefits by not paying the full cost of staffing the armed servicesThe cost which he escapes are the additional sums need to acquire men voluntarily for the services or those sums offered as payment by draftees to be exempted“Let-him-buy-his-way-out” or “buy-in” systemsWith systems the full cost of recruitment would be brought to bear on taxpayersThe draft is an externality caused by forbidding negotiation

The Concept and Role of Property RightsThe Concept and Role of Property RightsRole of property rights in internalization of externalities

A law which establishes the right of a person to his freedom would necessitate a payment on the part of a firm or taxpayer sufficient to cover the cost of using that person’s labor

A law which gives the firm clear title to slave labor would necessitate that the slave-owners take into account the sums that slaves are willing to pay for their freedom

It is the prohibition of a property rights adjustment and establishment of ownership title that precludes the internalization of external costs and benefits

The Emergence of Property RightsThe Emergence of Property RightsEmergence of property rights can best be understood by their association with the emergence of new or different beneficial and harmful effects

New techniques, and new ways of doing the same things, and doing new things all invoke harmful and beneficial effects that society is not used to.

New property rights emerge in response to the desires of the interacting persons for adjustment to the new benefit-cost possibilities

The Emergence of Property RightsThe Emergence of Property RightsProperty rights develop to internalize externalities when gains of internalization become larger that the cost of internalization

Increased internalization results from changes in economic values, development of new technologies, opening of new markets, and improving outdated property rights

Communities preference for private ownership versus state ownership plays an important role in interpretation

The Emergence of Property Rights:The Emergence of Property Rights:Native Americans and Land ownership

A close relationship existed, both geographically and historically between the development of private rights in land and the development of the commercial fur trade

This example illustrates the role played by property rights adjustments in taking into account externalities---over hunting game

Before fur trade, hunting was carried out for food and clothing for individual families

Hunting was practiced freely and without assessing the impact on other hunters

Externality of over-hunting was of small significance and so was not taken into account and no private land holdings

The Concept and Role of Property Rights:The Concept and Role of Property Rights:Native Americans and Land ownership

Consequences of Fur TradeValue of furs to Native Americans was increased considerablyAs a result of increased economic value, the scale of hunting activity rose sharplyThis increase caused the property rights system to change in the direction required to take into account the economic effects made important by the fur trade

The Result of Fur TradeSeasonal allotment system of huntingMade it economic to encourage the husbanding of fur-bearing animals

The Concept and Role of Property The Concept and Role of Property Rights:Rights:Native Americans and Land ownership

The thesis is consistent with findings of the absence of such rights among Indians of southwestern plainsNo plains animals of commercial value comparable to fur-bearing animalsAnimals of the plains primarily graze and wander over large tracts of landValue of establishing boundaries to prevent hunting territories is reduced due to the high cost of preventing the animals from moving to adjacent parcels.The externality is not worth taking into account

The Concept and Role of Property Rights:The Concept and Role of Property Rights:Native Americans and Land ownership

Forest animals confine their territories to small areas so the cost of internalizing the effects of husbanding them is reduced. This cost reduction, coupled with higher commercial value made it productive to establish private hunting lands

Examples of highly developed private family rights to hunting lands can be found, which went so far as to include inheritance

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property Rights

Forms of ownership include communal, private and state

Communal ownership means a right, which can be exercised by all members of the community.

Right to walk on a city sidewalkCommunity denies to the state or individual citizens the right to interfere with any person’s exercise of communally owned rights.

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property Rights

Private OwnershipThe community recognizes the right of the owner to exclude others from exercising the owner’s private rights

State OwnershipState may exclude anyone from the use of a right as long as the state follows accepted political procedures for determining who may not use state-owned property.

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property RightsLand Ownership Example

Communal Ownership

Private Ownership

Over hunt and overwork land because some of the costs are borne by others

Attempts to maximize present value by taking into account alternative future time streams of benefits and costs

Negotiation cost high, many people

Negotiation cost low, one owner

Not possible to bring full expected benefits & costs of future generations to bear on current users

Acts as a broker whose wealth depends on how well he takes into account the competing claims of present and future

Great number of externalities Internalizes many of external costs associated with communal

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property Rights

Externalities that accompany private ownership of property do not affect all owners, and only necessary for few to reach an agreement that takes externalities into account

Increase in the number of owners in the communality of property leads to an increase in the cost of internalizing

Reduction in negotiating costs that accompanies private right allows most externalities to be internalized at a rather low cost.

Exception is when the cost of a group of private owners getting together to combat an externality is too costly, soot example.

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property Rights

Two market options for land paradigmContractual agreement among owners that deals with external effectsSome owners buy out othersWhich option is cheaper will determine the method chosen.Multiple externalities require several contracts

Outright purchase may be cheaper to negotiate and police

The greater the diseconomies of scale the more contractual agreements will be used

Coalescence & Ownership of Property RightsCoalescence & Ownership of Property Rights

Publicly-Held CorporationsException to the idea that ownership is an individual affair

Economies of scale exist in operating, but not in provision of capital

Hence owners form a joint-stock companyIf all owners participate in each decision cost of negotiating becomes too high

Hence a delegation of authority takes place de factoStructure of ownership creates externalities

Inclusion of limited liability to reduce effect of de facto management and ownershipShareholders then own shares and not the corporation causing ownership to become largely individual again

ConclusionsConclusionsDual tendencies for ownership to rest with individuals and for the extent of an individual’s ownership to accord with the minimization of all costs (Land Paradigm)Not clear how widely applicable the paradigm is i.e. Patents and copyrightsAll problems of externalities are closely analogous to those which arise in the land ownership example and the relevant variables are identical