Origin and assignment of property rights

In a seminal article on the emergence and function of property rights, Demsetz (1967) pointed out the fundamental link between property rights and exter­nalities. Externalities are defined to be costs or benefits that one party imposes on others while not taking account of them in his or her own decision making.

The Coase theorem

Coase (1960) provided the seminal discussion of the relationship among the assignment (or definition) of property rights, transaction costs and the effi­cient internalization of externalities. (Coase framed his discussion in the context of external costs, but the same logic applies to external benefits.) Coase began by noting that economists traditionally viewed external costs as requiring government intervention (coercion) to ensure the efficient outcome. According to this ‘Pigouvian’ view, the government first identifies the ‘cause’ of the external harm (for example, a rancher whose cattle stray onto a farm­er’s land and damage his crops) and then imposes a tax or fine on that party, thereby inducing him to curtail his activities to the efficient level (for exam­ple, by reducing his herd size or fencing his land).

Coase’s work provided an important critique of the Pigouvian view.

Suppose, in contrast, that the rancher is awarded the right to allow his cattle to stray without penalty (the case of an ‘open range’). The traditional view would hold that the rancher will expand his herd inefficiently because he will ignore the cost suffered by the farmer. Coase argued, however, that if transaction costs between the farmer and rancher are low enough, the parties will engage in a bargain whereby the farmer pays the rancher to reduce the number of straying cattle to the socially efficient number. In other words, the farmer will purchase the right to be free of damage from inefficiently straying cattle.

This example shows that, regardless of how initial property rights are assigned in externality settings, the efficient outcome can be achieved with­out government intervention if transaction costs are low. This conclusion is known as the Coase theorem. Another way of stating the theorem is that the initial assignment of property rights, as determined, for example, by the rule of liability, is irrelevant for the final allocation of resources (Demsetz, 1972).

The irrelevance of the law with respect to resource allocation when trans­action costs are low was one important insight of Coase’s analysis; another has to do with the notion of causation in externality settings. As noted above, the traditional view of externalities identifies the cause of the external harm and taxes or fines that party. This implies a one-way causal relationship from the ‘injurer’ (rancher) to the ‘victim’ (farmer). Coase pointed out that caus­ation is actually reciprocal in the sense that both parties simultaneously cause the harm.

It follows that the designation of the ‘injurer’ and ‘victim’ are, in a sense, products of the initial assignment of the right. To illustrate this point, con­sider the case of Spur Industries v. Del E. Webb Development Co. (1972). This was a nuisance case brought by a residential developer to shut down a feedlot that emitted offensive odours. The court ordered the lot to shut down but, because it was pre-existing, the developer was required to pay its reloca­tion costs. Thus the developer would only shut down the feedlot if he valued elimination of the nuisance more than the cost of relocating the feedlot to its next-best site. This is the efficient relocation criterion, assuming that the feedlot did not foresee residential development when it made its initial loca­tion choice (Posner, 2003, pp. 62-3). Note that, in this case, the court’s award of damages to the feedlot for its losses implicitly assigned the role of ‘victim’ to the feedlot (by virtue of its having been ‘first in time’) and ‘injurer’ to the developer.

Although the foregoing examples have shown that the initial assignment of rights does not matter for resource allocation in a zero transaction cost world, it does matter for the distribution of wealth. Specifically, the party who is endowed with the property right receives something of value which the other party must purchase if he or she values it more highly. Thus the initial assignment of rights dictates the direction of monetary payments that will occur in moving to the final (efficient) allocation.

To this point we have considered a world in which transaction costs are zero or low. In most real-world settings, however, significant transaction costs are present (see, for example, the case studies in Ellickson, 1991). In those cases, the assignment of rights may have allocative effects, suggesting that property law needs to be sensitive to the bargaining costs of the parties to a dispute.

As a final point regarding the assignment of property rights, note that Coase’s analysis, while emphasizing the role of bargaining as opposed to third-party intervention in externality cases, nevertheless maintains the view of the state ‘as the sole creator of operative rules of entitlements among individuals’ (Ellickson, 1991, p. 4). This view ignores the importance of social customs and norms for defining rights and allocating resources in many settings. Economic analysis of these situations often appeals to the notion of ‘spontaneous order’ (or ‘order without law’) to explain the emer­gence of socially desirable outcomes in the absence of state or legal intervention (see generally Barzel, 1989, and Ellickson, 1991).