The Competitiveness of Nations in a Global Knowledge-Based Economy
Harold Demsetz
Towards a Theory of Property
Rights
American Economic
Review, 57 (2
May, 1967,
347-359.
Content
The Concept and Role of Property
Rights
The
Emergence of Property Rights
The Coalescence and Ownership of Property
Rights
When a transaction is concluded in the marketplace, two
bundles of property rights are exchanged. A bundle of rights often attaches to a
physical commodity or service, but it is the value of the rights that determines
the value of what is exchanged. Questions addressed to the emergence and
mix of the components of the bundle of rights are prior to those commonly asked
by economists. Economists usually
take the bundle of property rights as a datum and ask for an explanation of the
forces determining the price and the number of units of a good to which these
rights attach.
In this paper, I seek to fashion some of the elements of
an economic theory of property rights. The paper is organized into three parts.
The first part discusses briefly
the concept and role of property rights in social systems. The second part offers some guidance for
investigating the emergence of property rights. The third part sets forth some principles
relevant to the coalescing of property rights into particular bundles and to the
determination of the ownership structure that will be associated with these
bundles.
The Concept and Role of Property
Rights
In the world of Robinson Crusoe property rights play no
role. Property rights are an
instrument of society and derive their significance from the fact that they help
a man form those expectations which he can reasonably hold in his dealings with
others. These expectations find
expression in the laws, customs, and mores of a society. An owner of property rights possesses the
consent of fellowmen to allow him to act in particular ways. An owner expects the community to prevent
others from interfering with his actions, provided that these actions are not
prohibited in the specifications of his rights.
It is important to note that property rights convey the
right to benefit or harm oneself or others. Harming a competitor by producing
superior products may be permitted, while shooting him may not. A man may be permitted to benefit himself
by shooting an intruder but be prohibited from selling below a price floor.
It is clear, then, that property
rights specify how persons may be benefited and harmed, and, therefore, who must
pay whom to modify the actions taken by persons. The recognition of this leads easily to
the close relationship between property rights and
externalities.
347
Externality is an ambiguous concept. For the purposes of this paper, the
concept includes external costs, external benefits, and pecuniary as well as
nonpecuniary externalities. No
harmful or beneficial effect is external to the world. Some person or persons always suffer or
enjoy these effects. What converts
a harmful or beneficial effect into an externality is that 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, and this is what the term shall mean here. “Internalizing” such effects refers to a
process, usually a change in property rights, that enables these effects to bear
(in greater degree) on all interacting persons.
A primary function of property rights is that of guiding
incentives to achieve a greater internalization of externalities. Every cost and benefit associated with
social interdependencies is a potential externality. One condition is necessary to make costs
and benefits externalities. The
cost of a transaction in the rights between the parties (internalization) must
exceed the gains from internalization. In general, transacting cost can be large
relative to gains because of “natural” difficulties in trading or they can be
large because of legal reasons. In
a lawful society the prohibition of voluntary negotiations makes the cost of
transacting infinite. Some costs
and benefits are not taken into account by users of resources whenever
externalities exist, but allowing transactions increases the degree to which
internalization takes place. For
example, it might be thought that a firm which uses slave labor will not
recognize all the costs of its activities, since it can have its slave labor by
paying subsistence wages only. This
will not be true if negotiations are permitted, for the slaves can offer to the
firm a payment for their freedom based on the expected return to them of being
free men. The cost of slavery can
thus be internalized in the calculations of the firm. The transition from serf to free man in
feudal
Perhaps one of the most significant cases of
externalities is the extensive use of the military draft. The taxpayer benefits by not paying the
full cost of staffing the armed services. The costs which he escapes are the
additional sums that would be needed to acquire men voluntarily for the services
or those sums that would be offered as payment by draftees to taxpayers in order
to be exempted. With either
voluntary recruitment, the “buy-him-in” system, or with a
“let-him-buy-his-way-out” system, the full cost of recruitment would be brought
to bear on taxpayers. It has always
seemed incredible to me that so many economists can recognize an externality
when they see smoke but not when they see the draft. The familiar smoke example is one in
which negotiation costs may be too high (because of the large number of
interact-
348
ing parties) to make it worthwhile to internalize all
the effects of smoke. The draft is
an externality caused by forbidding negotiation.
The role of property rights in the internalization of
externalities can be made clear within the context of the above examples. A law which establishes the right of a
person to his freedom would necessitate a payment on the part of a firm or of
the taxpayer sufficient to cover the cost of using that person’s labor if his
services are to be obtained. The
costs of labor thus become internalized in the firm’s or taxpayer’s decisions.
Alternatively, a law which gives
the firm or the taxpayer clear title to slave labor would necessitate that the
slaveowners take into account the sums that slaves are willing to pay for their
freedom. These costs thus become
internalized in decisions although wealth is distributed differently in the two
cases. All that is needed for
internalization in either case is ownership which includes the right of sale.
It is the prohibition of a property
right adjustment, the prohibition of the establishment of an ownership title
that can thenceforth be exchanged, that precludes the internalization of
external costs and benefits.
There are two striking implications of this process that
are true in a world of zero transaction costs. 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 (except that different wealth distributions may
result in different demands). 1 For example, the efficient mix of civilians and military
will result from transferable ownership no matter whether taxpayers must hire
military volunteers or whether draftees must pay taxpayers to be excused from
service. For taxpayers will hire
only those military (under the “buy-him-in” property right system) who would not
pay to be exempted (under the “let-him-buy-his-way-out” system). The highest bidder under the
“let-him-buy-his-way-out” property right system would be precisely the last to
volunteer under a “buy-him-in” system. 2
We will refer back to some of these points later. But for now,
1. These implications are derived by R. H. Coase, “The
Problem of Social Cost,” J. of Law and Econ., Oct., 1960, pp.
1-44.
2. If the demand for civilian life is unaffected
by wealth redistribution, the assertion made is correct as it stands. However, when a change is made from a
“buy-him-in” system to a “let-him-buy-his-way-out” system, the resulting
redistribution of wealth away from draftees may significantly affect their
demand for civilian life; the validity of the assertion then requires a
compensating wealth change. A
compensating wealth change will not be required in the ordinary case of profit
maximizing firms. Consider the
farmer-rancher example mentioned by Coase. Society may give the farmer the right to
grow corn unmolested by cattle or it may give the rancher the right to allow his
cattle to stray. Contrary to the
Coase example, let us suppose that if the farmer is given the right, he just
breaks even; i.e., with the right to be compensated for corn damage, the
farmer’s land is marginal. If the
right is transferred to the rancher, the farmer, not enjoying any economic rent,
will not have the wherewithal to pay the rancher to reduce the number of head of
cattle raised. In this case,
however, it will be profitable for the rancher to buy the farm, thus merging
cattle raising with farming. His
self-interest will then lead him to take account of the effect of cattle on
corn.
349
enough groundwork has been laid to facilitate the
discussion of the next two parts of this paper.
The Emergence of Property
Rights
If the main allocative function of property rights is
the internalization of beneficial and harmful effects, then the emergence of
property rights can be understood best by their association with the emergence
of new or different beneficial and harmful effects.
Changes in knowledge result in changes in production
functions, market values, and aspirations. New techniques, new ways of doing
the same things, and doing new things - all invoke harmful and beneficial
effects to which society has not been accustomed. It is my thesis in this part of the paper
that the emergence of new property rights takes place in response to the
desires of the interacting persons for adjustment to new benefit-cost
possibilities.
The thesis can be restated in a slightly different
fashion: property rights develop to internalize externalities when the gains of
internalization become larger than the cost of internalization. Increased
internalization, in the main, results from changes in economic values, changes
which stem from the development of new technology and the opening of new
markets, changes to which old property rights are poorly attuned. A proper interpretation of this assertion
requires that account be taken of a community’s preferences for private
ownership. Some communities will
have less well-developed private ownership systems and more highly developed
state ownership systems. But, given
a community’s tastes in this regard, the emergence of new private or state-owned
property rights will be in response to changes in technology and relative
prices.
I do not mean to assert or to deny that the adjustments
in property rights which take place need be the result of a conscious endeavor
to cope with new externality problems. These adjustments have arisen in Western
societies largely as a result of gradual changes in social mores and in common
law precedents. At each step of
this adjustment process, it is unlikely that externalities per se were
consciously related to the issue being resolved. These legal and moral experiments may be
hit-and-miss procedures to some extent but in a society that weights the
achievement of efficiency heavily, their viability in the long run will depend
on how well they modify behavior to accommodate to the externalities associated
with important changes in technology or market values.
A rigorous test of this assertion will require extensive
and detailed empirical work. A
broad range of examples can be cited that are consistent with it: the
development of air rights, renters’ rights, rules for
350
liability in automobile accidents, etc. In this part of the discussion, I shall
present one group of such examples in some detail. They deal with the development of private
property rights in land among American Indians. These examples are broad ranging and come
fairly close to what can be called convincing evidence in the field of
anthropology.
The question of private ownership of land among
aboriginals has held a fascination for anthropologists. It has been one of the intellectual
battlegrounds in the attempt to assess the “true nature” of man unconstrained by
the “artificialities” of civilization. In the process of carrying on this
debate, information has been uncovered that bears directly on the thesis with
which we are now concerned. What
appears to be accepted as a classic treatment and a
Leacock clearly established the fact that a close
relationship existed, both historically and geographically, between the
development of private rights in land and the development of the commercial fur
trade. The factual basis of this
correlation has gone unchallenged. However, to my knowledge, no theory
relating privacy of land to the fur trade has yet been articulated. The factual material uncovered by Speck
and Leacock fits the thesis of this paper well, and in doing so, it reveals
clearly the role played by property right adjustments in taking account of what
economists have often cited as an example of an externality - the overhunting of
game.
Because of the lack of control over hunting by others,
it is in no person’s interest to invest in increasing or maintaining the stock
of game. Overly intensive hunting
takes place. Thus a successful hunt
is viewed as imposing external costs on subsequent hunters - costs that are not
taken into account fully in the determination of the extent of hunting and of
animal husbandry.
Before the fur trade became established, hunting was
carried on primarily for purposes of food and the relatively few furs that were
required for the hunter’s family. The externality was clearly present.
Hunting could be practiced freely
and was carried on without assessing its impact on other hunters. But these external effects were of
such
3. Eleanor Leacock, American Anthropologist
(American Anthropological Asso.), Vol. 56, No. 5, Part 2,
Memoir No. 78.
4. Cf., Frank G. Speck, “The Basis of American Indian
Ownership of Land,” Old Penn Weekly Rev.
(
small significance that it did not pay for anyone to
take them into account. There did
not exist anything resembling private ownership in land. And in the Jesuit Relations,
particularly Le Jeune’s record of the winter he spent with the Montagnes in
1633-34 and in the brief account given by Father Druilletes in 1647-48, Leacock
finds no evidence of private land holdings. Both accounts indicate a socioeconomic
organization in which private rights to land are not well
developed.
We may safely surmise that the advent of the fur trade
had two immediate consequences. First, the value of furs to the Indians
was increased considerably. Second,
and as a result, the scale of hunting activity rose sharply. Both consequences must have increased
considerably the importance of the externalities associated with free hunting.
The property right system began to
change, and it changed specifically in the direction required to take account of
the economic effects made important by the fur trade. The geographical or distributional
evidence collected by Leacock indicates an unmistakable correlation between
early centers of fur trade and the oldest and most complete development of the
private hunting territory.
By the beginning of the eighteenth century, we begin to
have clear evidence that territorial hunting and trapping arrangements by
individual families were developing in the area around
The next step toward the hunting territory was probably
a seasonal allotment system. An
anonymous account written in 1723 states that the “principle of the Indians is
to mark off the hunting ground selected by them by blazing the trees with their
crests so that they may never encroach on each other… By the middle of the century these
allotted territories were relatively stabilized.”
6
The principle that associates property right changes
with the emergence of new and reevaluation of old harmful and beneficial effects
suggests in this instance that the fur trade made it economic to encourage the
husbanding of fur-bearing animals. Husbanding requires the ability to
prevent poaching and this, in turn, suggests that socioeconomic changes in
property in hunting land will take place. The chain of reasoning is consistent with
the evidence cited above. Is it
inconsistent with the absence of similar rights in property among the
southwestern Indians?
Two factors suggest that the thesis is consistent with
the absence of
5. Eleanor Leacock, op. cit., p.
15.
6. Eleanor Leacock, op. cit., p.
15.
352
similar rights among the Indians of the southwestern
plains. The first of these is that
there were no plains animals of commercial importance comparable to the
fur-bearing animals of the forest, at least not until cattle arrived with
Europeans. The second factor is
that animals of the plains are primarily grazing species whose habit is to
wander over wide tracts of land. The value of establishing boundaries to
private hunting territories is thus reduced by the relatively high cost of
preventing the animals from moving to adjacent parcels. Hence both the value and cost of
establishing private hunting lands in the Southwest are such that we would
expect little development along these lines. The externality was just not worth
taking into account.
The lands of the
To conclude our excursion into the phenomenon of private
rights in land among the American Indians, we note one further piece of
corroborating evidence. Among the
Indians of the Northwest, highly developed private family rights to hunting
lands had also emerged - rights which went so far as to include inheritance.
Here again we find that forest
animals predominate and that the West Coast was frequently visited by sailing
schooners whose primary purpose was trading in furs. 7
7. The thesis is consistent with the development of other
types of private rights. Among
wandering primitive peoples the cost of policing property is relatively low for
highly portable objects. The owning
family can protect such objects while carrying on its daily activities. If these objects are also very useful,
property rights should appear frequently, so as to internalize the benefits and
costs of their use. It is generally
true among most primitive communities that weapons and household utensils, such
as pottery, are regarded as private property. Both types of articles are portable and
both require an investment of time to produce. Among agriculturally-oriented peoples,
because of the relative fixity of their location, portability has a smaller role
to play in the determination of property. The distinction is most clearly seen by
comparing property in land among the most primitive of these societies, where
crop rotation and simple fertilization techniques are unknown, or where land
fertility is extremely poor, with property in land among primitive peoples who
are more knowledgeable in these matters or who possess very superior
land. Once a crop is grown by the
more primitive agricultural societies, it is necessary for them to abandon the
land for several years to restore productivity. Property rights in land among such people
would require policing cost for several years during which no sizable output is
obtained. Since to provide for
[sustenance these people must move to new
land, a property right to be of value to them must be associated with a portable
object. Among these people it is common to find property rights to the crops,
which, after harvest, are portable, but not to the land. The more advanced
agriculturally based primitive societies are able to remain with particular land
for longer periods, and here we generally observe property rights to the land as
well as to the crops.]
HHC: [bracketed] displayed
on page 354 of original]
The Coalescence and Ownership of
Property Rights
I have argued that property rights arise when it becomes
economic for those affected by externalities to internalize benefits and costs.
But I have not yet examined the
forces which will govern the particular form of right ownership. Several idealized forms of ownership must
be distinguished at the outset. These are communal ownership, private
ownership, and state ownership.
By communal ownership, I shall mean a right which can be
exercised by all members of the community. Frequently the rights to till and to hunt
the land have been communally owned. The right to walk a city sidewalk is
communally owned. Communal
ownership means that the community denies to the state or to individual citizens
the right to interfere with any person’s exercise of communally-owned rights.
Private ownership implies that the
community recognizes the right of the owner to exclude others from exercising
the owner’s private rights. State
ownership implies that the 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. I
shall not examine in detail the alternative of state ownership. The object of the analysis which follows
is to discern some broad principles governing the development of property rights
in communities oriented to private property.
It will be best to begin by considering a particularly
useful example that focuses our attention on the problem of land ownership.
Suppose that land is communally
owned. Every person has the right
to hunt, till, or mine the land. This form of ownership fails to
concentrate the cost associated with any person’s exercise of his communal right
on that person. If a person seeks
to maximize the value of his communal rights, he will tend to overhunt and
overwork the land because some of the costs of his doing so are borne by others.
The stock of game and the richness
of the soil will be diminished too quickly. It is conceivable that those who own
these rights, i.e., every member of the community, can agree to curtail the rate
at which they work the lands if negotiating and policing costs are zero. Each can agree to abridge his rights.
It is obvious that the costs of
reaching such an agreement will not be zero. What is not obvious is just how large
these costs may be.
Negotiating costs will be large because it is difficult
for many per-
354
sons to reach a mutually satisfactory agreement,
especially when each hold-out has the right to work the land as fast as he
pleases. But, even if an agreement
among all can be reached, we must yet take account of the costs of policing the
agreement, and these may be large, also. After such an agreement is reached, no
one will privately own the right to work the land; all can work the land but at
an agreed upon shorter workweek. Negotiating costs are increased even
further because it is not possible under this system to bring the full expected
benefits and expected costs of future generations to bear on current
users.
If a single person owns land, he will attempt to
maximize its present value by taking into account alternative future time
streams of benefits and costs and selecting that one which he believes will
maximize the present value of his privately-owned land rights. We all know that this means that he will
attempt to take into account the supply and demand conditions that he thinks
will exist after his death. It is
very difficult to see how the existing communal owners can reach an agreement
that takes account of these costs.
In effect, 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
claims of the present and the future. But with communal rights there is no
broker, and the claims of the present generation will be given an uneconomically
large weight in determining the intensity with which the land is worked. Future generations might desire to pay
present generations enough to change the present intensity of land usage. But they have no living agent to place
their claims on the market. Under a
communal property system, should a living person pay others to reduce the rate
at which they work the land, he would not gain anything of value for his
efforts. Communal property means
that future generations must speak for themselves. No one has yet estimated the costs of
carrying on such a conversation.
The land ownership example confronts us immediately with
a great disadvantage of communal property. The effects of a person’s activities on
his neighbors and on subsequent generations will not be taken into account
fully. Communal property results in
great externalities. The full costs
of the activities of an owner of a communal property right are not borne
directly by him, nor can they be called to his attention easily by the
willingness of others to pay him an appropriate sum. Communal property rules out a
“pay-to-use-the-property” system and high negotiation and policing costs make
ineffective a “pay-him-not-to-use-the-property” system.
The state, the courts, or the leaders of the community
could attempt to internalize the external costs resulting from communal property
by allowing private parcels owned by small groups of person with
similar
interests. The logical groups in terms of similar
interests, are, of course, the family and the individual. Continuing with our use of the land
ownership example, let us initially distribute private titles to land randomly
among existing individuals and, further, let the extent of land included in each
title be randomly determined.
The resulting private ownership of land will internalize
many of the external costs associated with communal ownership, for now an owner,
by virtue of his power to exclude others, can generally count on realizing the
rewards associated with husbanding the game and increasing the fertility of his
land. This concentration of
benefits and costs on owners creates incentives to utilize resources more
efficiently.
But we have yet to contend with externalities. Under the communal property system the
maximization of the value of communal property rights will take place without
regard to many costs, because the owner of a communal right cannot exclude
others from enjoying the fruits of his efforts and because negotiation costs are
too high for all to agree jointly on optimal behavior. The development of private rights permits
the owner to economize on the use of those resources from which he has the right
to exclude others. Much
internalization is accomplished in this way. But the owner of private rights to one
parcel does not himself own the rights to the parcel of another private sector.
Since he cannot exclude others from
their private rights to land, he has no direct incentive (in the absence of
negotiations) to economize in the use of his land in a way that takes into
account the effects he produces on the land rights of others. If he constructs a dam on his land, he
has no direct incentive to take into account the lower water levels produced on
his neighbor’s land.
This is exactly the same kind of externality that we
encountered with communal property rights, but it is present to a lesser degree.
Whereas no one had an incentive to
store water on any land under the communal system, private owners now can take
into account directly those benefits and costs to their land that accompany
water storage. But the effects on
the land of others will not be taken into account
directly.
The partial concentration of benefits and costs that
accompany private ownership is only part of the advantage this system offers.
The other part, and perhaps the
most important, has escaped our notice. The cost of negotiating over the
remaining externalities will be reduced great1y. Communal property rights allow anyone to
use the land. Under this system it
becomes necessary for all to reach an agreement on land use. But the externalities that accompany
private ownership of property do not affect all owners, and, generally speaking,
it will be necessary for only a few to reach an agreement that takes these
effects into account. The cost of
negotiating an internalization of these effects
356
is thereby reduced considerably. The point is important enough to
elucidate.
Suppose an owner of a communal land right, in the
process of plowing a parcel of land, observes a second communal owner
constructing a dam on adjacent land. The farmer prefers to have the stream as
it is, and so he asks the engineer to stop his construction. The engineer says, “Pay me to stop.”
The farmer replies, “I will
be happy to pay you, but what can you guarantee in return?” The engineer answers, “I can guarantee
you that I will not continue constructing the dam, but I cannot guarantee that
another engineer will not take up the task because this is communal property; I
have no right to exclude him.” What
would be a simple negotiation between two persons under a private property
arrangement turns out to be a rather complex negotiation between the farmer and
everyone else. This is the basic
explanation, I believe, for the preponderance of single rather than multiple
owners of property. Indeed, an
increase in the number of owners is an increase in the communality of property
and leads, generally, to an increase in the cost of
internalizing.
The reduction in negotiating cost that accompanies the
private right to exclude others allows most externalities to be internalized at
rather low cost. Those that are not
are associated with activities that generate external effects impinging upon
many people. The soot from smoke
affects many homeowners, none of whom is willing to pay enough to the factory to
get its owner to reduce smoke output. All homeowners together might be willing
to pay enough, but the cost of their getting together may be enough to
discourage effective market bargaining. The negotiating problem is compounded
even more if the smoke comes not from a single smoke stack but from an
industrial district. In such cases,
it may be too costly to internalize effects through the
marketplace.
Returning to our land ownership paradigm, we recall that
land was distributed in randomly sized parcels to randomly selected owners.
These owners now negotiate among
themselves to internalize any remaining externalities. Two market options are open to the
negotiators. The first is simply to
try to reach a contractual agreement among owners that directly deals with the
external effects at issue. The
second option is for some owners to buy out others, thus changing the parcel
size owned. Which option is
selected will depend on which is cheaper. We have here a standard economic problem
of optimal scale. If there exist
constant returns to scale in the ownership of different sized parcels, it will
be largely a matter of indifference between outright purchase and contractual
agreement if only a single, easy-to-police, contractual agreement will
internalize the externality. But,
if there are several externalities, so that several such contracts will need to
be negotiated, or
if the contractual agreements should be difficult to
police, then outright purchase will be the preferred course of
action.
The greater are diseconomies of scale to land ownership
the more will contractual arrangement be used by the interacting neighbors to
settle these differences. Negotiating and policing costs will be
compared to costs that depend on the scale of ownership, and parcels of land
will tend to be owned in sizes which minimize the sum of these costs.
8
The interplay of scale economies, negotiating cost,
externalities, and the modification of property rights can be seen in the most
notable “exception” to the assertion that ownership tends to be an individual
affair: the publicly-held corporation. I assume that significant economies of
scale in the operation of large corporations is a fact and, also, that large
requirements for equity capital can be satisfied more cheaply by acquiring the
capital from many purchasers of equity shares. While economies of scale in operating
these enterprises exist, economies of scale in the provision of capital do not.
Hence, it becomes desirable for
many “owners” to form a joint-stock company.
But if all owners participate in each decision that
needs to be made by such a company, the scale economies of operating the company
will be overcome quickly by high negotiating cost. Hence a delegation of authority for most
decisions takes place and, for most of these, a small management group becomes
the de facto owners. Effective ownership, i.e., effective
control of property, is thus legally concentrated in management’s hands. This is the first legal modification, and
it takes place in recognition of the high negotiating costs that would otherwise
obtain.
The structure of ownership, however, creates some
externality difficulties under the law of partnership. If the corporation should fail,
partnership law commits each shareholder to meet the debts of the corporation up
to the limits of his financial ability. Thus, managerial de facto
ownership can have considerable external effects on shareholders. Should property rights remain unmodified,
this externality would make it exceedingly difficult for entrepreneurs to
acquire equity capital from wealthy individuals. (Although these individuals have recourse
to reimbursements from other shareholders, litigation costs will be high.) A second legal modification, limited
liability, has taken place to reduce the effect of this externality.
9 De facto
management ownership and limited liability combine to
minimize the overall cost of operating large enterprises. Shareholders are essentially lenders of
equity capital and not owners, although they do participate in such infrequent
decisions as
8. Compare this with the similar rationale given by R. H.
Coase to explain the firm in “The Nature of the Firm,” Economica,
New Series, 1937, pp. 386-405.
9. Henry G. Manne discusses this point in a forthcoming
book about the American corporate system.
358
those involving mergers. What shareholders really own are their
shares and not the corporation. Ownership in the sense of control again
becomes a largely individual affair. The shareholders own their shares, and
the president of the corporation and possibly a few other top executives control
the corporation.
To further ease the impact of management decisions on
shareholders, that is, to minimize the impact of externalities under this
ownership form, a further legal modification of rights is required. Unlike partnership law, a shareholder may
sell his interest without first obtaining the permission of fellow shareholders
or without dissolving the corporation. It thus becomes easy for him to get out
if his preferences and those of the management are no longer in harmony. This “escape hatch” is extremely
important and has given rise to the organized trading of securities. The increase in harmony between managers
and shareholders brought about by exchange and by competing managerial groups
helps to minimize the external effects associated with the corporate ownership
structure. Finally, limited
liability considerably reduces the cost of exchanging shares by making it
unnecessary for a purchaser of shares to examine in great detail the liabilities
of the corporation and the assets of other shareholders; these liabilities can
adversely affect a purchaser only up to the extent of the price per
share.
The 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 is clear in the land ownership paradigm. The applicability of this paradigm has
been extended to the corporation. But it may not be clear yet how widely
applicable this paradigm is. Consider the problems of copyright and
patents. If a new idea is freely
appropriable by all, if there exist communal rights to new ideas, incentives for
developing such ideas will be lacking. The benefits derivable from these ideas
will not be concentrated on their originators. If we extend some degree of private
rights to the originators, these ideas will come forth at a more rapid pace.
But the existence of the private
rights does not mean that their effects on the property of others will be
directly taken into account. A new
idea makes an old one obsolete and another old one more valuable. These effects will not be directly taken
into account, but they can be called to the attention of the originator of the
new idea through market negotiations. All problems of externalities are closely
analogous to those which arise in the land ownership example. The relevant variables are
identical.
What I have suggested in this paper is an approach to
problems in property rights. But it
is more than that. It is also a
different way of viewing traditional problems. An elaboration of this approach will, I
hope, illuminate a great number of social-economic
problems.
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