Property rights define who owns what and what the owner can do with what he owns. At the minimum, the owner must be compensated for attenuation of his rights and the owner can transfer his property rights to the highest bidder. Clear ownership rights encourage owner investment to develop his property and transferability ensures that the property ends up in the hands of those who can use it most efficiently. When property rights exist by custom or by default, they cannot be monetized or transferred. Any property rights which cannot be monetized and transferred either because they exist by custom or by default (i.e., de facto rights) or because they are governed by use-it-or-lose-it clauses would lead to less efficient uses (see Dying for Money and Windfall Profit).
The integrity of property rights depends on enforcement cost. The lower the enforcement cost, the more meaningful are the rights. For example, the invention of barbed wire has been credited with the successful development of cattle ranching in the American West because the wire provided an inexpensive means of enforcing ranch boundaries. The over-exploitation of commons resources is a result of failure to define and enforce property boundaries.
The failure to define the property rights to some resources gives rise to positive and negative externality (in other words, external benefit and external cost). In other words, a transaction can confer benefit or impose cost to third parties without compensation only if the rights to some resources have not been defined. For example, auto exhaust imposes external cost simply because the right to clean air has not been clearly defined.
Many resources have remained commons because property rights cannot be technically or cheaply defined or enforced. Such difficulties might have explained why these resources have been commonly owned by custom.
If the property rights of clean air can be easily defined and enforced, the parties involved will have an incentive to negotiate a solution to internalize the spillover effects. The resulting pollution will settle on an efficient level provided that the negotiation cost and enforcement cost is negligible.* This insight is commonly known as the Coase Theorem1 after the Nobel Laureate economist Ronald Coase.
Un-internalized externality leads to either under-use or over-use. Specifically, the benefits that flow to unintended parties will not be reflected in private demand. As a result, private demand is lower than otherwise. When these unintended benefits must be paid for, private demand would increase. Given the existing supply, higher private demand would lead to higher price and larger quantity demanded (see External Cost and External Benefit). For example, granting patents to innovative inventions is a way to internalize external benefits for the inventors.
On the other hand, the costs that are imposed on unintended parties will not be taken into account by private supply. As a result, private supply is higher than otherwise. When these costs generated by the private suppliers must be paid for, private supply would decrease. Given the existing demand, lower private supply would lead to higher price and smaller quantity supplied (see External Cost and External Benefit). For example, congestion pricing is a way to internalize external cost generated by drivers with less urgent needs.
- Resources will be efficiently allocated regardless of the initial assignment of property rights if the cost of negotiating a settlement of spillover effects is zero.
- *When property rights cannot be completely enforced, residual externality may still exist even though the rights have been clearly defined.