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I think we've all seen that the Demsetz question shows up on all the tests. I thought I'd take a stab at it and invite the rest of you to edit (i.e., correct) my response.

Post script - I wrote basically this answer on the test and got 15/20 points. It would be good if someone who got closer to 20/20 would share their answer. - Mark


In "Toward a Theory of Property Rights," Harold Demsetz presents the argument that in a world of zero transaction costs, that "The output mix that results when the exchange of property rights is allowed is efficient and the mix is independent of who is assigned ownership." Briefly explain his argument and the state the property rights assignment. Conclude your answer with a real-world example of a problem that would be solved by property rights assignment or acknowledgment of those assignments.

The output mix Demsetz refers to is the use of property and economic resources. When property rights are assigned, it allows consumers and suppliers to negotiate for the use or non-use of property. Without property rights, interested parties have no reference for negotiating the use of the property. In a zero-transaction cost world, all things could be assigned ownership, nothing would be left as an externality, and the use or non-use of all things could be negotiated between interested parties. It follows naturally that market transactions will ensure that the most efficient use of resources once all resources can be traded.

In a more realistic world there is a cost to assigning and enforcing property rights – i.e., transaction costs. Because the acts of assigning and enforcing property rights have a cost, property rights will not be assigned unless the marginal benefit of assigning property rights outweighs the marginal cost of not assigning property rights. The marginal cost of not assigning property rights is measured in terms of the cost of the negative externalities that have not been internalized through the assignment of property rights.

Demsetz uses the example of the fur trade in his article to demonstrate the impact of property right assignment. A group called the Montagnes in Canada hunted fur in forests that were communal property until the advent of the European fur trade caused the price of furs to rise dramatically. Prior to the European fur trade, the market value of animals was low enough that there was little risk of overhunting in the Montagnes’ forests, therefore communal ownership was an efficient means of controlling the forests. The depletion of the stock of animals in the forest was a potential externality of communal ownership. However, the marginal cost of this externality was low because the market value of low market value of the animals. When the fur prices rose dramatically, the likelihood of depleting the animal stock also rose dramatically, increasing the marginal cost of the excessive hunting externality. Once the marginal cost of the externality exceeded the cost of assigning and enforcing property rights to the forests, the Montagnes began assigning property rights to the forest. The result was the property owners husbanded the animal population in the forests and ensured that hunting remained at a sustainable level.


Note: While the question prompt cites Demsetz's article, in the quoted sentence Demsetz is summarizing R. H. Coase's The Problem of Social Cost (see Demsetz, Toward a Theory of Property Rights, pg. 349, fn 1). As such, it is possible that a full credit answer would ignore Demsetz's thesis about the the role of property rights in the internalization of external costs and benefits, and instead focus squarely on the argument made by Coase.

The argument is explainable as such: when two property owners, A and B, are using their property for incompatible purposes such that A's activities impose costs on B, then the two parties will bargain such that the end result is an economically efficient outcome; necessary conditions are that property rights are well-defined and exchangeable, and that there are no transaction costs; an efficient outcome will result regardless of how property rights are initially assigned.

An example given by Coase is that of the cattle-raiser A against the crop-raiser B where A's cattle cause damage to B's crops. There are three relevant parameters: whose product is greater valued by the market, who is assigned the initial property rights, and what is the cost of prevention (i.e., given a fence will prevent the damage to the crops, is the cost of the fence higher or lower than the total product value for the person not assigned the rights?); this means there are eight potential outcomes.

A's product value is greater

(1) A receives rights; B's prevention cost greater than B's profits. Since it is more costly to prevent the damage that the crops are worth in this scenario, B will curtail crop growth to the point that losses are wholly mitigated (i.e., given the size of A's herd, crop production is reduced until the value of the crops damaged equals the savings that result from foregoing expenditure on cultivating those crops); this releases the resources needed for the foregone crops back to the market for other more valued uses. This results in an efficient outcome.

(2) A receives rights; B's prevention cost less than B's profits. Since the profits from the crops exceed the cost of preventing them from being damaged, B will pay to build the fence and maintain the current crop size. This results in an efficient outcome.

(3) B receives rights; A's prevention cost greater than A's profits. Since A must compensate B for crop damage, and since the fencing is more costly than the value of the damaged crops, A will curtail raising cattle to the point where losses are wholly mitigated (i.e., given the size of B's crop, herd size is reduced until the value of the crops damaged equals the savings that result from foregoing expenditure on raising those foregone cattle); this releases the resources needed for the foregone cattle back to the market for other more valued uses. This results in an efficient outcome.

(4) B receives rights; A's prevention cost less than A's profits. Since the profits from the cattle are greater than the cost of preventing them from damaging the crops, A will pay to build the fence and maintain the current herd size. This results in an efficient outcome.

B's product value is greater

(5) A receives rights; B's prevention cost greater than B's profits. In this scenario, the market values the crops greater than the cattle, thus B is willing to pay A to reduce cattle production to the point that the payment for the marginal cattle reduction is equal to or less than the gain in crop value from the marginal reduction in cattle production. This results in an efficient outcome.

(6) A receives rights; B's prevention cost less than B's profits. As with (2) above, B in this scenario simply builds the fence. This preserves the value of the cattle, and also the value of the crops less the cost of the fence. This results in an efficient outcome.

(7) B receives rights; A's prevention cost greater than A's profits. Since it is more costly to prevent the damage than the crops are worth in this scenario, A will curtail cattle production until losses are wholly mitigated (i.e., given the size of B's crop, herd size is reduced until the value of the crops damaged equals the savings that result from foregoing expenditure on raising those foregone cattle); this releases the resources needed for the foregone cattle back to the market for other more valued uses. This results in an efficient outcome.

(8) B receives rights; A's prevention cost less than A's profits. Since the profits from cattle production are greater than the cost of the fence, A will pay to build the fence. This results in an efficient outcome.

As can be seen, in every case, the result is efficient, regardless of how the property rights are assigned.

-- J.D.

WEW_Econ_811

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