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The Exchange and Enforcement of Property Rights Author(S): Harold Demsetz Source: Journal of Law and Economics, Vol The Exchange and Enforcement of Property Rights Author(s): Harold Demsetz Source: Journal of Law and Economics, Vol. 7, (Oct., 1964), pp. 11-26 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/724917 Accessed: 05/05/2008 21:44 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=ucpress. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We enable the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact [email protected]. http://www.jstor.org THE EXCHANGE AND ENFORCEMENT OF PROPERTY RIGHTS* HAROLD DEMSETZ Universityof Chicago OUReconomic system, with its specializationof economicactivities into separateownership and decisionunits, requiresboth controlover goods and exchangeof goods if it is to cope with the diversityof wants of specialist producers.This paperis concernedwith the fact that the exchangeof goods and the maintenanceof controlover the use of goodsimpose costs on traders and owners.It is also concernedwith the cost of governmentalternatives to the marketplace. We seek to establishboth the importanceand the wide role of these costs in economiclife. A largepart of our argumentwill be illustratedby two importantcontro- versiesin welfareeconomics in which we will show, on the one hand, that zero pricingof scarcegoods need not resultin inefficiency,and, on the other, that zero pricingof "public"goods may result in inefficiency.The standard criticismsof resourceallocation by the market,which turn on the market's failureto price "external"effects and on its tendencyto price"public" goods, are shown to be invalid. To do this we extend the well knownaxiom that thereis no such thing as a free scarcegood by includingsuch goodsas mar- kets, governmentbureaus, and policingdevices. Throughoutthis paper, our attentionis confinedto the problemof efficiency within the frameworkof smoothlyrunning markets and governments,in the sense that we assumethat persons,whether in their capacityas civil servants or as privatecitizens, do not makearithmetic errors in calculating,or, at least, that they do not tend to makemore errors in one role than in another.We do not concernourselves with problemsof monopolyby either a firm or the government,but the problemof imperfectknowledge is treated. Instead of "externaleffects" or "neighborhoodeffects" we will use the phrase"side effects" to identifythose for whichno accountseems to be taken in the market place. This avoids the flavor of location and of being necessarily outside of the market place that seem to be associated with the morecommon names for these effects. * The author wishes to thank Armen A. Alchian, Gary S. Becker, William H. MeckIing, Peter Pashigian, and George J. Stigler for their comments. 11 12 THE JOURNAL OF LAW AND ECONOMICS I. EXCHANGECOST Recent R. Developments. H. Coase,1 in an important article written recently for this Journal, demonstrates that there is, in general, nothing special about side effects that rules out the possibility of their being taken account of by the market. These effects can be taken into account by market transactions between the parties affected once the courts have established who has what right of action. Under competitive conditions and assuming zero exchange costs, these transactions will result in an efficient solution to the scarcity problem. Thus, if ranchers are given the right to allow their cattle roam to and the cattle stray accidentally onto unfenced farm land, it will be in the farmer's interest to bring the damage they cause to the rancher's attention by offering to pay the rancher to reduce the number of cattle foraging nearby. If the rancher disregards this offer, he sacrifices a potential receipt equal to the crop damage. Thus, the crop damage becomes a private cost to the rancher of raising additional cattle and will be taken account of in his calculations. Moreover, Coase points out the efficiency of the solution with respect to the number of cattle and the size of the crops in the absence of exchange costs is independent of whether the farmer or rancher is legally liable for the damage. The party not held liable, of course, acquires the right to act in ways which may have harmful side effects. The assignment of the for liability cropdamage to the rancher would lead to a direct accounting for this cost in his operations andhe would need to decide whether to reduce his herdor pay the farmer to reduce the crophe plants. Whether the farmer will findit worthwhile to pay enough to the rancher to reduce his herd or whether the rancher can pay enough to the farmer to reduce the area he cultivates depends on whether the value lost because of the cropreduction is greater or less than the value lost because the size of theherd is reduced. Whichever way therights are initially assigned, the outcome of the subsequent bargaining will be that which maximizes the value of output. Coasehas advanced the analysis of theroles that can be played by the market and the government astep beyond its previous position. For now Coasehas shown that if exchange costs are positive, it is necessary to ask whethergovernment cantake the harmful effects of anaction into account at less than market cost can the or, indeed, if the resulting resource realignment isworth the costof taking the side effects into account atall. Misapplication of Optimality Theorems. The question which asks whether or not realignment is worthwhile brings to light an improper usage to which wefrequently have put our optimality theorems. The cost of using the market relative to the costof using a political mechanism has seldom been considered explicitlyor in detail in the bulk of the theory of welfare economics. This 1 Coase,The Problem of Social Cost, 3 J. Law & Econ. 1-44 (1960). PROPERTY RIGHTS 13 has led to an improper usage of those theorems. As a consequence of the conventional approach to these problems, it has not been recognized that the very conditions under which side effects are believed to lead to inefficiency are those conditions for which the welfare theorems used are inapplicable. The usual analysis of market inefficiency in such cases attributes the diffi- culty to the absence of markets in which "appropriate" prices for measuring side effects can be revealed.2 But absence of a market or of a price can be consistent with efficiency when optimality theorems are appropriately inter- preted. For produced goods, the optimality theorems require equalities among various marginal rates of substitution. These same optimality conditions, however, do not require such equalities for goods and services that are not produced in the final efficient equilibrium; for these we have corner solutions involving inequalities. Thus, a basic premise in requiring equalities is that we are talking about goods which we require to be produced in positive quantities. We then turn to the competitive model and observe that market prices will often bring about the equalities required for produced commodities and services. But, we ask, what 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 and that, therefore, the required equalities will be absent. The allegation is that even perfectly competitive markets fail to achieve efficiency. But, this reason- ing 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. If this service is not being produced some inequalities (instead of the equalities required for produced goods) among our marginal rates of substitution and marginal rates of transformation may be consistent with efficiency, as will be the case if the cost of taking account of side effects through either the market or the government exceeds the value of realigning 2 Cf. Arrow, Uncertaintyand the Welfare Economics of Medical Care, 53 Am. Econ. Rev. 941, 944-45 (1963): An individualwho fails to be immunizednot only risks his own health, a disutility which presumablyhe has weighedagainst the utility of avoiding the procedure,but also that of others. In an ideal price system, there would be a price which he would have to pay to anyone whose health is endangered,a price sufficientlyhigh so that the others would feel compensated;or, alternatively,there would be a price which would be paid to him by others to induce him to undergo the immunizationprocedure .... It is, of course, not hard to see that such price systems could not, in fact, be practical; to approximate an optimal state it would be necessary to have collective intervention in the form of subsidy or tax or compulsion. and Bator, The Anatomy of Market Failure, 72 Q.J. Econ. 351, 353-54 (1958): Pareto-efficient. points . are characterizedby a complete set of marginal-rate-of- substitution .
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