• The Demsetz Theory

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the lake. To the extent the neighbor succeeds, the restocking will be a positive externality experienced (in part) by you, the landowner.2

Starting with a famous article about externalities written by Ronald Coase in 1960,3 economists have long been aware that one way to internalize positive and negative externalities is through contracts. Suppose the landowner in the previous example identifies the would-be dumper before the pollution takes place. Such an identification might lead to a contract between the owner and the dumper, in which the dumper would agree, in return for some consideration, not to dispose of the waste material in the lake. The offer of such a contract would internalize to the would-be dumper the negative externalities that otherwise would be borne by the landowner, because now the dumper would have to take those costs into account—as represented by the price the landowner is willing to pay to secure the agreement of the dumper not to pollute. Similarly, the neighbor thinking of starting a fish hatchery might decide to condition his or her willingness to do so on the other landowners on the lake agreeing to contribute to the hatchery. The offer of such a contract would internalize the positive externalities associated with the hatchery, because now the neighbor would take into account more of the benefit when incurring the cost of providing it.

The Demsetz theory posits that another way of internalizing externalities associated with the use of resources is by establishing

property rights in the resource. Property rights, as Demsetz understood them, are rights to exclude others from specific things

2.It is commonly thought that negative externalities result in excessive activity levels, and positive externalities lead to underprovision of the good in question. Although this is true in many situations, it is not always the case. A flower garden is nonrival, in the sense that additional people can enjoy it at no extra cost. Nevertheless, you may enjoy planting it so much that you will do so regardless of whether additional passers-by enjoy it or not. In such a case the spillover benefit is called an “irrelevant” externality.

3.R. H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960). We will return to Coase at greater length in Chapter 8.

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or resources. By creating such exclusion rights and conferring them on an identified owner, many of the benefits and costs associated with the use of the resource—which otherwise would be experienced as externalities by others—will instead be borne by the owner. By giving the owner exclusive control over the resource, decisions that affect the value of the resource in a positive or negative direction will be captured by the owner. The owner thus has a powerful incentive to take these benefits and costs into account in deciding how to use the resource, just as one would if one could enter into contracts with other affected persons about these benefits and costs.

As Demsetz further observed, this incentive extends to costs and benefits that will be realized after the owner’s death. As he put it, “an owner of a private right to use land acts as a broker whose wealth depends on how well he takes into account the competing demands of the present and the future.”4 When resources are held in an open-access state, in contrast, there is no such broker to represent the interests of the future, because there is no owner who can internalize the claims of future generations. The result is likely to be that “the claims of the present generation are given an uneconomically large weight in determining the intensity with which the land is worked.”5

Consider again, by way of illustration of these points, the small lake in our previous example. Suppose, first, that no one owns the lake; it is an open-access resource (see Chapter 2). Under this arrangement, if one person pollutes the lake, this imposes a cost in the form of reduced opportunities to catch fish in the future. This cost will be borne by all persons who might want to fish in the lake. Consequently, most of the cost is experienced as an externality by persons other than the one who pollutes. Similarly, if one person were to stock the lake, this would create a benefit in the form of

4.Id. at 355.

5.Id.

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increased opportunities to catch fish in the future. But again, most of the benefit would be experienced as an externality by persons other than the one doing the stocking. The predictable result of this open-access arrangement would be too much polluting—overconsumption of the resource—and too little stocking—underinvestment in the resource.

Now, change the arrangement so that one person is the owner of the lake and hence can exclude all other persons from the lake. If the owner of the lake pollutes, the cost this imposes, in terms of reduced opportunities to catch fish in the future, will be borne entirely by the owner. Likewise, if the owner decides to stock the lake, the benefits this creates, in terms of increased opportunities to fish in the future, will be captured entirely by the owner. Even if the owner is too old to look forward to catching these fish during the owner’s own lifetime, the stocking will increase the value of the lake, and the owner can capture this higher value by selling or donating the lake to others who can look forward to catching them. Because the owner internalizes the full costs of pollution and the full benefits of stocking, the owner has an incentive to weigh these costs against the advantages of polluting activities, and to weigh the risks and potential return from stocking. The problems of overconsumption and underinvestment associated with the open-access regime are significantly reduced.6

If property has these desirable cost-internalization features, why aren’t all resources owned? Here Demsetz offered an important insight: Just as Coase pointed out that making and enforcing contracts to control externalities is costly, so Demsetz observed that

6.If property rights are limited in scope, as they always are, then externalities will never be completely eliminated by creating property rights in resources. There will always be spillovers from one unit of property that affect other units or actors. For example, if the owner of the lake destroys a marshy portion of the lake that serves as a habitat for migratory birds, this could impose costs on persons who like to go bird watching or bird hunting in areas outside the lake. The destruction of the marsh imposes an external cost on bird watchers and hunters in other areas where the birds migrate.

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establishing and enforcing property rights is costly. It is necessary to define the resources subject to ownership, specify how owners are identified, set up an institution to resolve disputes over ownership, and devise mechanisms for enforcing ownership rights. These activities consume resources that could be devoted to doing something else. Putting together the advantages of property, in terms of internalizing the costs and benefits of resource use, and the costs of property, in terms of the resources needed to establish and enforce property rights, we get the complete Demsetz theory. Stated affirmatively, this says that property rights in resources will be established when the internalization benefits associated with property rights exceed the costs associated with establishing and enforcing property rights. Stated negatively, if the costs of establishing and enforcing property rights exceed the benefits of internalization from establishing and enforcing property rights, resources will remain in an unowned (open-access) state.

The Demsetz theory has several important implications for the types of things that will be owned as property. First, for something to be governed by a property regime, there must be enough demand for the resource relative to its supply that internalization of externalities associated with use of the resource will produce significant benefits. Some things are so plenteous that, even if they are very important to sustaining human life, there will be no perception of scarcity and hence no point in internalizing externalities. The atmosphere and the oceans have historically been regarded as the “common right” of all mankind, in part because they have been regarded as so plentiful that no one would bother to try to assert exclusive rights over them. This can change of course. In recent decades, one important resource associated with oceans— fisheries—have become increasingly distressed, and stocks of fish have declined, sometimes precipitously. In response, we have seen movement toward establishing exclusive economic zones in ocean fisheries, regulatory limits on total catch in certain ocean fisheries, and even the creation of systems of individual permits to fish that are bought and sold, called individual tradeable quotas (ITQs).

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Evidence suggests that ITQs where implemented have generally halted and sometimes reversed the trend toward collapse of fisheries.7 This broad movement toward exclusion rights in response to scarcity is consistent with what the Demsetz theory would predict.

Second, if something is regarded as having no value, or negative value, it is also unlikely that the thing will be treated as property. Animal droppings, for example, are generally regarded as a nui- sance—a negative value product—and ordinarily no one claims property rights in animal waste. Tellingly, however, if such waste does have value, disputes over ownership can arise. This is suggested by a famous case about horse manure gathered in piles at the side of a public roadway.8 The manure had no value to the trav-

elers whose animals dropped it. But once collected it had positive value as fertilizer, and this gave rise to a dispute over who owned it (the gatherer as it happened).

Third, property in a given class of resources is unlikely to exist if there are high costs of establishing and enforcing such rights. A famous example is provided by rangeland in the American west.9 Rangeland was regarded as an open-access resource for most of the nineteenth century. Any one could graze animals on the open range. This led to overgrazing, which quite arguably reduced total output from raising livestock. In theory, division of the land into separately owned tracts would have offered a solution, but this was far from costless. One problem was that traditional fencing materials, such as wooden rails, were scarce on the plains, which made it expensive to demarcate individual grazing tracts by fencing. With the invention of barbed wire, it became much cheaper to divide rangeland

7.Christopher Costello et al., Can Catch Shares Prevent Fisheries Collapse?, 321 Science 1678 (2008).

8.Haslem v. Lockwood, 37 Conn. 500 (1871).

9.See Terry L. Anderson & Peter J. Hill, The Evolution of Property Rights: A Study of the American West, 18 J.L. & Econ. 163 (1975).

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into separately owned parcels. Consistent with the Demsetz theory, widespread enclosure of the land soon followed. Cheaper fencing material lowered the costs of defining and enforcing private property in land, and this changed the cost-benefit equation.

In general, rights in some assets are easier to delineate and enforce as property than other assets. Rights in land and tangible personal property such as clothing and automobiles are relatively easy to delineate and enforce as property. Rights in other resources, such as wild birds, water in underground aquifers, or abstract ideas are much more difficult to delineate and enforce. This can be because the resource moves around (birds), or is difficult to observe (underground water), or is inherently difficult to specify (abstract ideas). Not surprisingly, we find that objects that fall into one or more of these categories tend to resist treatment as property.

Notice that the Demsetz theory identifies some general conditions in which property, especially in the sense of exclusion rights, are likely to emerge, but has nothing to say about whether the response will be to create traditional private property, communal property, public property, or some type of public regulation such as a permitting scheme. Demsetz suggested that the particular history and cultural conventions of the society will be important in determining the “type” of property that evolves. This is undoubtedly true, but does not provide much guidance in predicting the path of future institutional development.

Notice too that the Demsetz theory fails to specify a causal mechanism by which property rights get created. Resources are held in an open-access state at time T1, under one combination of benefits and costs, and then move to a property regime at time T2, under a different combination of benefits and costs. But we are not told exactly how the change from T1 to T2 comes about. Commentators have debated whether the causal mechanism is more likely to be bottom-up, with property evolving from informal social norms, or top-down, with “property entrepreneurs” lobbying the government to pass laws that authorize new forms of property.

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The top-down theory has a certain plausibility if creating a new type of property entails a large upfront investment. Assume a lake subject to open access yields $1000 worth of fish to ten different fishers. Assume further that creating a system of exclusion rights, such as a program of ITQs, would raise the value of the yield to $2000, by eliminating the take of young fish before they spawn. Finally, assume that the costs of lobbying the government to create the ITQs would be $400. If the existing ten fishers have relatively equal-sized operations, such that they would most likely divide the ITQs equally, it will be difficult to raise $400 for the lobbying campaign. Each fisher would gain only about $100 from adopting this scheme, so unless there is some way to compel each fisher to help underwrite the lobbying costs, the change may not happen. Suppose, in contrast, that one fisher has a disproportionately large operation, equal to 50 percent of the take, and that this operator would likely command 50 percent of the ITQs. Such an operator would stand to gain $500, which is enough to create an incentive for this one operator alone to incur the $400 lobbying costs needed to make the change. This example suggests that property rights may be most likely to emerge in markets with heterogeneous producers, some of whom would benefit disproportionately from the creation of property.10

The principal point established by the Demsetz theory is that there are practical constraints on the domain of property. Plenteous resources, negative or low-valued resources, and resources that are hard to pin down or observe are unlikely candidates for inclusion in the domain of property. Conditions that make enforcement of property rights difficult, such as a scarcity of fencing materials or the absence of a functioning court system, will also make it difficult for property to thrive.

10.See Katrina Miriam Wyman, From Fur to Fish: Reconsidering the Evolution of Private Property, 80 N.Y.U. L. Rev. 117 (2005). Conversely, to get multiple parties to contribute, homogeneity of interests is likely to facilitate bargaining. See Gary D. Libecap, Contracting for Property Rights 22–23 (1989).