Toward a Theory of
Property Rights
Harold Demsetz, (1967) American
Economic Review, 57 (May): 347-359
Group 1:
Meredith, Barclay, Woo-je, & Kumar
Property Rights: Introduction
When 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 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 Rights
Externalities
External costs, external benefits, pecuniary and nonpecuniary 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 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 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 Rights
Example : Military Draft
Taxpayer benefits by not paying the full cost of staffing
the armed services
The 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” systems
With systems the full cost of recruitment would be
brought to bear on taxpayers
The draft is an externality caused by forbidding
negotiation
The Concept and Role of Property Rights
Role 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 Rights
Emergence 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 Rights
Property 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:
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:
Native Americans and Land ownership
Consequences of Fur Trade
Value of furs to Native Americans was increased
considerably
As a result of increased economic value, the scale of hunting
activity rose sharply
This 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 Trade
Seasonal allotment system of hunting
Made it economic to encourage the husbanding of furbearing animals
The Concept and Role of Property Rights:
Native Americans and Land ownership
The thesis is consistent with findings of the absence of
such rights among Indians of southwestern plains
No plains animals of commercial value comparable to furbearing animals
Animals of the plains primarily graze and wander over large
tracts of land
Value 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:
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 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 sidewalk
Community denies to the state or individual citizens
the right to interfere with any person’s exercise of
communally owned rights.
Coalescence & Ownership of Property Rights
Private Ownership
The community recognizes the right of the owner
to exclude others from exercising the owner’s
private rights
State Ownership
State 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 Rights
Land 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 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 Rights
Two market options for land paradigm
Contractual agreement among owners that deals
with external effects
Some owners buy out others
Which 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 Rights
Publicly-Held Corporations
Exception 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 company
If all owners participate in each decision cost of
negotiating becomes too high
Hence a delegation of authority takes place de facto
Structure of ownership creates externalities
Inclusion of limited liability to reduce effect of de facto
management and ownership
Shareholders then own shares and not the corporation
causing ownership to become largely individual again
Conclusions
Dual 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 copyrights
All problems of externalities are closely
analogous to those which arise in the land
ownership example and the relevant variables
are identical