Property rights theory
Property rights theory emerged in the 1960s following Coase’s “Problem of social cost” (Alchian 1961, 1965; Demsetz 1964, 1967). It explicitly takes the individual as given and institutions and organizations as constraints on her rational choice, the aim being “to explain the behavior of the firm and other institutions by observing individual action within the organization”; therefore, “marginalism is not rejected, the standard techniques are merely extended to new applications” (Furubotn and Pejovich 1972: 1138, original emphasis).
The differences with neoclassical economics come from the study of different structures of property rights (implicit and capitalist in classical and neoclassical theories), the introduction of transaction costs, and the assumption of maximization of utility by individual agents (managers, owners, workers) instead of maximization of profit by a firm. Property rights theory analyses how different systems of property rights determine individual behaviour and economic efficiency, asserts the superiority of private property rights over other forms of property, and argues that this more efficient form tends to prevail.A property right over a good or service is defined as the socially enforced right to select use of this good or service. A private property right also encompasses the rights to raise revenue from the good and to sell this right; it is fractionable between these three different rights (to use, to raise revenue, and to sell), which can be owned by different persons, and is thus separable. The capitalist firm and the large corporation derive their efficiency from the exploitation of the partitionability, separability and alienability of private property (Alchian and Demsetz 1972).
The efficiency of private ownership is generally offered to argue against the communal property of a scarce resource, which entails overuse and negative externalities.
Demsetz (1967) famously argued that the Labrador Peninsula evolved from communal property of forests to private ownership because of the development of the European fur trade at the end of the seventeenth century, which made animals scarce, increasing their value, and raising the advantages of private property rights over their costs. His thesis is that “property rights develop to internalize externalities when the gains of internalization become larger than the cost of internalization. Increased internalization... results from changes in economic values, changes which stem from the development of new technology and the opening of new markets” (Demsetz 1967: 350).Since private property rights are seldom perfect, someone other than the owner may use his good: this is an externality. If transaction costs were nil and property rights clearly defined, a negotiation would be possible, leading to an optimal outcome (Coase 1960). Property rights theory insists that remaining externalities are therefore due to positive transaction costs or ill-defined property rights, the two concepts being rather equivalent. Moreover, these transaction costs imply that the initial distribution of rights has an impact on the allocation of resources.