Toward a Theory of Property Rights

Previously we looked at Harold Demsetz’s ‘The Exchange and Enforcement of Property Rights’, which mostly focused on the efficiency implications of various transaction costs in property rights. In this paper, ‘Toward a Theory of Property Rights’, Demsetz does some more economic exploration of property rights, addressing three topics: the role of property rights in social systems, how property rights might emerge in a society, and what aspects shape the particular bundle of property rights that emerge.

I. The Concept and Role of Property Rights

Property rights are an instrument of society and derive their significance from the fact that they help a man form those expectations which he can reasonably hold in his dealings with others…

[P]roperty rights specify how persons may be benefited and harmed, and therefore, who must pay whom to modify the actions taken by persons. The recognition of this leads easily to the close relationship between property rights and externalities…

What converts a harmful or beneficial effect into an externality is that 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…

A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities. Every cost and benefit associated with social interdependence is a potential externality. One condition is necessary to make costs and benefits externalities [:] The cost of a transaction in the rights between the parties (internalization) must exceed the gains from internalization.

The classic example of an externality is pollution. Imagine we have two firms set up on a river, one downstream from the other. The upstream firm is a steel plant, and the downstream firm is a bottled water facility. The steel plant releases pollution into the water, which then effects the bottled water plant. This pollution is an externality: the steel plant does not have to take account of the harm its actions have on the downstream firm, and so ‘too much’ steel is produced and ‘not enough’ bottled water.

In the Coasean world of low transaction costs, property rights can solve this problem. If the right to the water is assigned to the steel plant, then the bottling firm will either have divert some resources away from bottling and into purification, OR pay the steel firm to produce less. If the rights are assigned to the bottling plant, then the steel company has to produce less steel OR pay the bottling plant to allow it to produce more (which the plant could then use to purchase purification equipment). The amazing result Coase obtained is that the output mix is the same in either case, regardless of who is assigned the rights. The amount the bottling firm would pay the steel firm is the same the steel firm would be willing to pay the bottling firm, were rights assigned to the other.

All that is needed for internalization…is ownership which includes the right of sale. It is the prohibition of a property right adjustment, the prohibition of the establishment of an ownership title that can thenceforth be exchanged, that precludes the internalization of external costs and benefits.

So if it is costly to set up the rights to the water, then the internalization cannot proceed. In the real world, where pollution affects a great many people, transaction costs make such internalization extremely difficult. Perhaps those affected by pollution would all be willing to pay a polluter to reduce their output, but the difficulty in setting up such transactions is a major obstacle, and so individual property rights to clean air and water have never been established.

(From here, many leap to the conclusion that government action is therefore needed to address the pollution externality; this may be the case, but not necessarily so. See his previous paper as to why.)

II. The Emergence of Property Rights

But as the world changes, so does the cost-benefit calculation of establishing property rights. If pollution were such as to become extremely odious, the benefits of reducing it could become so great as to outweigh the costs of establishing property rights. Demsetz:

If the main allocative function of property rights is the internalization of beneficial and harmful effects, then the emergence of property rights can be understood best by their association with the emergence of new or different beneficial and harmful effects…

It is my thesis in this part of the paper that the emergence of new property rights takes place in response to the desires of the interacting persons for adjustment to the new benefit-cost possibilities.

The thesis can be restated in a slightly different fashion: property rights develop to internalize externalities when the gains of internalization become larger than the cost of internalization.

This makes intuitive sense, but is there evidence for such a claim? Demsetz points to an example among the Native Americans during the establishment of the European fur trade in North America. The story goes like this: in the Labrador Peninsula, the Innu people had no tradition of property rights in land prior to European contact, but developed a robust system as the fur trade grew.

Recall the ‘tragedy of the commons’, the situation where common, non-exclusive ownership of a resource leads to its overexploitation. This results because the externality of the reduced resource pool is not incorporated into the price individuals pay.

The Innu people certainly hunted the forests of Labrador and Quebec, but their numbers were never such that the externality of reduced hunting game was greater than the cost that would result from setting up such a system. However, once the demand from Europe greatly increased the value of fur animals, the cost of the externality became such that the Innu found that a system of property rights was on balance of positive value.

The principle that associates property right changes with the emergence of new and reevaluation of old harmful and beneficial effects suggests in this instance that the fur trade made it economic to encourage the husbanding of fur-bearing animals. Husbanding requires the ability to prevent poaching and this, in turn, suggests that socioeconomic changes in property in hunting land will take place. The chain of reasoning is consistent with the evidence cited above.

It’s a nice story but I have idea how close to accurate it is historically. Still, the framework of analysis is sound and I think it very helpful in thinking about why property rights exist where they exist, both geographically and sociologically.

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The Exchange and Enforcement of Property Rights, Part III

[Part I] [Part II]

Even if the case for a zero priced public good is made on second best efficiency grounds, the question remains of how to pay for the provision of that good. Governments can use the power of taxation to reallocate resources towards the production of the public good, but this has consequences of its own. Depending on how the tax is levied, it will lead to distortions elsewhere in the economy. Demsetz returns to the bridge example:

[T]he alternative methods of financing the building of bridges may also lead to inefficiency, especially by degrading valuation information elsewhere. This is most easily seen by supposing that an excise tax is levied on other goods to finance bridges. Such a tax will lead to inefficiently small rates of production of these other goods… [T]he levying of an income tax will inefficiently reduce the quantities of income generating activities undertaken by those taxed. A tax on property values, even one on rent, would tend to discourage the seeking out of more valuable uses of property. A head tax would have the least effect because it is not concentrated on particular activities. Even a head tax, one could argue, would alter a person’s choice of community… Taxes exclude just as do prices, so that on grounds of exclusion there is not much principle to guide us. Given these indirect costs of alternative methods of financing the provision of public goods, the desirability of zero-pricing is not at all clear, especially if the cost of policing is low.

Here Demsetz reminds us that we can’t consider the efficiency calculation of a public good in a vacuum. The possibility of distortion from taxes elsewhere in the economy should be taken into account as well. Usually economists hand wave away this question, or assume that the least distortionary tax can be used, but in matters of public policy in the real world it is rarely the case that the question of a public good and how to pay for it are entirely separate.

A recent example is illustrative. In Washington, DC, the city council recently raised taxes on rideshare transactions to pay for funding for the Metro, moving from a 1% to a 6% tax. Leaving aside whether the Metro is a public good (in the technical sense, obviously not since it is exclusionary), why should rideshares in particular be taxed to pay for Metro? If the desired social goal is increased mobility of people (usually the justification for public transit), then why would you tax the most flexible transit option available? From an economic standpoint, it makes no sense. From a political economy/public choice standpoint, the tying together of such proposals makes more sense: perhaps the marginal Lyft ride is converted to a public transit trip, leading to more revenue. 

Are there ways of getting around this problem of high exchange/police costs so that we can avoid the distortions of taxation? There are two alternatives Demsetz presents: extending the firm, and the practice of sale-in-combination (eg tie-ins).

Extending the firm is a fairly intuitive idea. If transactions costs are high and regular a firm will find it advantageous to simply buy their negotiating partner. Often this is vertical integration, where a producer buys the provider of a vital input; imagine Ford buying a steel plant. We’re currently seeing this happen in the health care sector, where insurance companies, PBMs, and pharmacies are starting to merge, partly to reduce the costs of constant negotiation.

Still other institutional arrangements have been devised to combine extensions of the firm with the sale-in-combination device. Department stores and shopping plazas are organizational devices for overcoming high police cost. The owner of the department store or shopping plaza can provide a general environment that is conducive for shopping, such as pleasant plantings, escalators, and other customer services that merchants who owned their own land might hesitate to pay for, hoping instead that neighboring landowners would incur the necessary expenses from which all would benefit. The enclosing of land into a single ownership entity which often undertakes to provide services usually provided by government from tax revenues, such as streets, sidewalks, refuse collection, and even police protection, allows the owner to exclude those who refuse to pay rentals which cover the cost of these services… The development of these institutional arrangements provides an interesting challenge to political institutions for the provision of many of the services generally presumed to be within the scope of the polling place.

This logic here has been extended to the idea of private cities, as Alex Tabarrok has written about.

Finally, exchange and police costs are not set in stone. Technological development offers ways of reducing these costs as well. The development of EZpass type technology allows for the far less costly provision of tolling, as well as dynamic pricing. Communications technologies in general have dramatically reduced all kinds of transactions costs. Remote monitoring and big data have reduced monitoring costs, allowing many large corporations to cut out lots of middle management positions and outsource tasks to specialized firms. Demsetz:

Attention is sometimes called to the fact that emerging technical developments will make the use of markets or government more economic than they now are. There are surely many instances where this is true. However, our analysis suggests that technological developments can operated in the opposite direction. At the same time that technology is reducing the cost of using these alternative institutional arrangements for economizing, it is also reducing the cost of constructing parking spaces, of developing fire resistant corn, and of mass producing automobiles. Whether or not it pays to increase the extent to which we exchange via markets, protect private property rights, or use alternative government devices depends on how much we will thereby reduce production cost and crop damage. Markets or their government alternatives should come into greater prominence only if technical developments lower the costs of these institutional arrangements more than they reduce the costs of producing parking spaces and cars and the cost of crop damage.

We must keep in mind costs are all relative; the absolute decrease in communications costs only matters to a firm insofar as it decreases relative to the others costs it faces.

This is an important paper, particularly for anyone interested in public policy issues. As always, it is important to keep in mind the difference between normative and positive claims. The claims about efficiency here are positive ones, and while they can inform our normative judgments, they are not meant to do so alone. There may be some policies we wish to embark on for moral reasons, regardless of the efficiency implications.

The Exchange and Enforcement of Property Rights, Part II

[Part I] [Part III]

Today we’re continuing with the discussion of Harold Demsetz’s 1964 paper, ‘The Exchange and Enforcement of Property Rights’. The author will give us a quick recap and then we’ll move onto the implications of his thesis for public goods:

[W]hat if some goods produce side effects which are not exchanged over a market? We answer that the market fails to provide us with incentives which will guide behavior to take account of the side effects… The allegation is that even perfectly competitive markets fail to achieve efficiency. But, this reasoning generally fails to take account of the fact that the provision of a market (for the side effect) is itself a valuable and costly service. Where a market, or the political action which would be its counterpart, does not exist, this service is not being produced…

In such cases [of high cost of market provision] zero amounts of market pricing or the government equivalent will be efficient. In asking the implications of the nonexistence of some markets, we seem to have forgotten the cost of providing market services or their government equivalent. The existence of price to facilitate exchange between affected parties has been too much taken for granted. A price for every good or service is not a necessary condition for efficiency, so that the absence of price does not imply that either market transactions or substitute government services are desirable.

A public good, if you recall, is both non-rivalrous and non-excludable (for a review see Wikipedia). Classic examples include national defense, breathable air, and over the air television. Unfortunately, the term public good is often used rather loosely, typically referring to any good with large positive externalities. It may be more helpful to think of public goods as those that are non-excluded vs non-excludable, as we’ll see.

The relevance of what we have been discussing for public goods is that if the cost of policing the benefits derived from the use of these goods is low, there is an excellent reason for excluding those who do not pay form using these goods. By such exclusion, we, or the market, can estimate accurately the value of diverting resources from other uses to the production of the public good.

Technically speaking, if the public good becomes excludable, it is no longer a public good; it has become a club good. Regardless, the non-rivalry of such goods does not mean they are costless to produce; the question of how much of society’s scarce resources should be deployed towards the creation of the ‘public’ good remains. Demsetz illustrates with the example of a free to use bridge:

Continue reading “The Exchange and Enforcement of Property Rights, Part II”

The Exchange and Enforcement of Property Rights

[Part II] [Part III]

Fundamental to any theory of economics is the notion of property rights. When economists speak of property rights, of course we don’t mean only property in the sense of land, as it is commonly used. Property rights are a social institution in which it is understood that the holder of a property right has exclusive access to the good in question. It is understood in our society that we can’t walk into each other’s homes at will and take food and clothing. That is not the case in every society; why this is so is a question for another day.

Property rights on their own are not enough to result in an efficient allocation of goods. For that, the rights must be exchangeable. In communist societies, an individual had a right to a set allocation of goods (x number of boots per year), but those rights were not exchangeable (de jure, de facto was another matter).

Given property rights and free exchange, markets result in an efficient allocation of goods. However, those are fairly sizable assumptions; what happens when we relax them? That is the question the University of Chicago economist Harold Demsetz sought to answer in his 1964 paper, ‘The Exchange and Enforcement of Property Rights.’

Continue reading “The Exchange and Enforcement of Property Rights”

Is There Accounting for Taste? Part III

[Part I] [Part II]

First, a quick finishing up of Stigler-Becker, and then on to Caplan.

Fashions and Fads

The existence of fashions and fads…seems an especially striking contradiction of our thesis of the stability of tastes. We find fashions in dress, food, automobiles, furniture, books, and even scientific doctrines… The rise and fall of fashions is often attributed to the fickleness of people’s tastes…

The obvious method of reconciling fashion with our thesis is to resort again to the now familiar argument that people consume commodities, and only indirectly to they consume market goods, so fashions in the market goods are compatible with stability in the utility function of commodities…

The commodity apparently produced by fashion goods is social distinction: the demonstration of alert leadership, or at least not lethargy, in recognizing and adopting that which will in due time be widely approved.

This commodity is somewhat different from those considered previously in that it depends on the social environment; if everyone in a society decided to increase their production of social distinction by 100%, everyone would end up in the same place. Social distinction is largely conserved in society; its supply is inelastic, and so only the distribution is what can be changed:

[D]istinction is scare and is to a large extent simply redistributed among persons: an increase in one person’s distinction generally requires a reduction in that of other persons. This is why people are often ‘forced’ to conform to new fashions.

This section is a little less developed than the others mathematically, but I still think it’s a good insight.

To finish up I want to quote at length from the paper’s conclusion, because it helps set the stage for the next paper.

Continue reading “Is There Accounting for Taste? Part III”

Is There Accounting for Taste? Part II

Last time I began going through the classic paper by George Stigler and Gary Becker, ‘De Gustibus Non Est Disputandum’, a work than aimed to extend the reach of neoclassical economic analysis into areas of human behavior long considered noneconomic.

By using a concept of ‘consumption capital’ that can be built up with experience, education, and other factors, we saw that addiction could be explained not as a change in tastes, but as a utility maximizing response to changes in said capital. Today we’ll finish up with the other three areas they address in the paper: Custom and Tradition; Advertising; and Fashions and Fads.

Continue reading “Is There Accounting for Taste? Part II”

Is There Accounting for Taste? Part I

Today I want to begin a review of two different accounts of human preference. One is George Stigler and Gary Becker’s seminal ‘De Gustibus Non Est Disputandum’. The other will be Bryan Caplan’s ‘Stigler-Becker versus Meyers-Briggs: why preference-based explanations are scientifically meaningful and empirically important’.

As setup last time, Stigler and Becker are seeking to extend the extend the use of neoclassical marginalist analysis beyond traditional markets:

[W]e are proposing the hypothesis that widespread and/or persistent human behavior can be explained by a generalized calculus of utility-maximizing behavior…

They focus on four areas: addiction, custom and tradition, advertising, and fashions and fads. All of these analyses are framed with ‘the new theory of consumer choice’, which is a rather clever extension of utility-maximizing theory. Normally, when modelling consumer utility, consumers choose a bundle of goods from the marketplace based on whatever gives them the most utility, and then consumption takes place immediately.

But when you buy a sack of potatoes, you don’t eat them as soon as you finish with checkout. The end product you will consume is not yet finished; the potatoes have to be transformed into a delicious massaman curry through further use of labor time and combination with other goods.

So instead of instantaneous consumption, consumers or household use goods from the market to create ‘commodities’, which are then used to produce utility. Simply by adding another step to the consumption process, a whole new range of behavior can be modeled.

The next extension to consider is the possibility of adding ‘capital’ to this production process. Capital is anything that aids in production and is not labor; it is not relegated to physical machinery. Practice is a form of capital building; you can work a little bit faster next time, get a little higher quality. You could buy a really nice pan, or take a cooking course.  This notion of building ‘consumption capital’ is the key to the argument, as applied to a range of human behaviors.

One of the main categories of behavior Stigler and Becker analyze is addiction. Normally behavior like addiction is seen as a change in preference: you didn’t have a taste for cigarettes, then you were exposed to them however many times, and now you have a preference for them. But using the capital consumption framework, both good and bad addictions can be explained holding tastes constant. The examples considered are music (good) and heroin (bad).

Imagine consuming music is not merely the act of listening in the moment; surely that yields some utility, but as with other arts, experience and education can be combined with the listening experience to obtain even greater utility.  For example, my appreciation of Beethoven’s symphonies was greater enhanced by learning about and listening to his contemporaries, the dominant structure of music at the time, and how he pushed against the formalism of the day.

So too it is with the Beatles; when I listen to the Fab Four, I’m not merely appreciating the production, the chord changes, and the songcraft; I’m also thinking about the cultural moment, the turn in the post-war British and American culture, the pressures of fame, interpersonal group dynamics, human frailty, and so on. All of this comes from having spent years increasing my ‘consumption capital’ of music. (For the other fans in the audience, someone has created an augmented Anthology podcast that I really enjoyed).

And when one has built up such consumption capital, the return the additional music listening becomes even greater; a music ‘addiction’ has formed:

On this interpretation, the (relative) consumption of music appreciation rises with exposure not because tastes shift in favor of music, but because its shadow price falls as skill and experience in the appreciation of music are acquired with exposure.

With a harmful addiction, the math is the same with the signs flipped. Consuming heroin destroys consumption capital in this model, so more and more of the drug is needed subsequently to obtain the same level of utility. Again, no change in tastes is necessary to explain the junkie’s behavior.

Of course, we know that in the real world, people *do* have differing susceptibilities to addiction, some of which seems to simply be genetic. But this shouldn’t be taken to mean the Stigler-Becker model is wrong; it may often be more useful to model addiction with the consumption capital concept than to develop a model based on brain chemistry.