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.