Towards a Theory of Property RightsHarold DemsetzThe American Economic ReviewVolume 57, Issue 2May, 1967, 347-359.IndexIntroductionThe Concept and Role of Property RightsThe Emergence of Property RightsThe Coalescence and Ownership of Property RightsIntroductionWhen 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 RightsIn 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.347Externality 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 Europe is an example of this process.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