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Hi everybody, welcome back.Last time, we saw in the dispute betweenthe LeRoy Fibre Company and the railroadthat if transaction costs were low, itdidn't matter how the court initiallydecided except for distributional reasons.But, what if transactions costs are high?What if there are many LeRoys along thetrain's route so that there's not onetransaction which has to be completedbetween the railroad and one LeRoy fibercompany.But let's assume a hundred differenttransactions that need to be undertakenbetween the single railroad.And let us say, a hundred identical LeRoyfiber companies lined up along the track.So, let me draw a little picture here.Here's the track, okay?And let's assume that rather than therebeing one LeRoy fiber company, say overhere, there's another LeRoy fiber companyhere, a third LeRoy fiber company, a

fourth, and so on, until there are 100Leroys all lined up.Say, one mile apart along the routebetween Chicago and Minneapolis that therailroad trains have to go through.So, let's further assume that the numbersbetween the railroad and each of theseLeRoys are identical.That is, there are now 100 property rightsat issue, 100 rights to throw sparks onthe near area of the 100 LeRoy FiberCompany's yards.And let's assume that for each of the 100

owners, the value of that property rightis $1,000 and that the value of theproperty right in each case to therailroad is $5,000 okay?So, now we have the same bargainingsituation that we had between the railroadand the single LeRoy company, replicated ahundred times.So, what will happen?Well, we can imagine that the president ofthe railroad will get on a hand car, oneof those things that rides along therailroad track and is propelled by a human

being pushing a lever up and down.So we'll draw in a little handcar with thelever and we'll put the president of thecompany on the handcar.And we'll have the handcar drive up to thefirst LeRoy, call this LeRoy number one.And so, the railroad starts to make a dealwith the LeRoy company.They spend a little time bargaining.It soons becomes apparent that the

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railroad is willing to pay enough to getthe right from the LeRoy company.And let's suppose that the railroadpurchases the first of the property rightsfor $2,000.Then, the first LeRoy company doesn't havethe property right.And the railroad company now has theproperty right.That LeRoy suffers $1,000 worth of damage,but is more then compensated by the $2,000that the railroad has paid for the right.And importantly, the railroad, we couldsay rings up a profit of $3000 on thatfirst negotiation.So, we can imagine that after having donethat first negotiation, the railroadchalks up on it's ledger a $3,000 profit.That is, it has paid $2,000 to the firstLeRoy company in order to purchase a rightthat the company would have paid $5,000 toget.And so, the difference is pure profit,surplus that the railroad receives by

buying something for $3,000 that it wouldhave paid up to $5,000 to get.Now, the railroad president gets back onhis handcart, he pumps the lever and hegoes to the second LeRoy company and theystart doing the same deal.And let's suppose that the second LeRoy,LeRoy 2, also sells the right for $2,000.And so, the railroad chalks up another$3,000 profit on the second of thenegotiations that it undertakes.And so, the railroad president gets backon his handcar and he drives to the third

Leroy.And now, the third LeRoy begins to say tohimself, it looks like the railroad ismaking out like a bandit on each of thesetransactions.And that's because each of my predecessorLeRoy companies, LeRoy 1 and LeRoy 2, areselling out too cheap.And so, the third owner says to himself,well maybe, even though I know that thetruth is that the property right is worthonly $1,000 to me, maybe I can hold out tothe railroad, lie to them, tell them that

the property right is worth $4,000 to me,or $6,000 to me.And then, I can tap into that surplus thatthe railroad has realized from those firsttwo purchases.That is, it's to everybody's advantage tohave other people come to terms with therailroad.So that, that LeRoy which has not yet cometo terms with the railroad is able to

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bargain with the railroad or to a largersurplus than the earlier LeRoys were ableto do.That is, as more and more deals are madebetween the railroad and some of theLeRoys, and the railroad surplus growslarger and larger and larger, theincentive for all of the LeRoys who havenot yet made a deal with the railroad isto conceal their true values in an attemptto extract as much of the surplus that therailroad is realizing from the other dealsin the deal that the railroad has to makewith these people.So, their hope is that if they're the100th LeRoy and the railroad has hundredsof thousand dollars worth of surplus inits ledger books, that the last LeRoy cansay, okay, I'll sell you my right for 15or 20 or $30,000.In the hopes that the railroad, havingcompleted 99 transactions will say, okay,we'll pay this extortionate price for thelast property right.

So, because of this situation, every LeRoyhas an incentive to try to be the verylast LeRoy that comes to terms with therailroad.And therefore, have the opportunity tobargain over the maximum amount of surplusthat the railroad can get.So, this is a variant of what theeconomists call the holdup problem.Every LeRoy has the incentive to be thelast one to come to terms with therailroad.Because if they're the last ones, then

they're in a position to bargain over thelargest surplus.And so, because of this incentive, everyLeRoy tries to become the last LeRoy tobargain with the railroad.And so, they all stall and refuse tobargain.And the railroad is unable to make any ofthe deals that it would have made, andwhich would have been mutually beneficial,not just to the railroad, but to that allof the LeRoys as well.What we've seen is that absent this holdup

problem, the company could make a dealwith each and every one of those LeRoysbecause each and every one of those LeRoysis a lower valuing owner of the relevantproperty right than the railroad is.But the holdup problem means that peoplehave an incentive, the LeRoys have anincentive not to come to terms with therailroad until everybody else has come toterms with the railroad.

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Which means that bargaining will not takeplace, and therefore, those gains ineconomic value that could have beenrealized by the hundred separatetransactions will not be undertaken.The transactions will not be undertaken,and so those gains in economic value willnot be realized.So, a decision for the railroad, alongHolmes' lines, that is to say, a decisionthat grants to the railroad a propertyright to throw sparks from carefullyoperated trains onto Leroy's yard makesall of the transactions that the railroadwould have to undertake with the Leroy's,had the Leroy's been granted the propertyright.Initially unnecessary, because underHolmes's rule, the railroad, the highervaluing property owner, would've beengiven the property right in the firstinstance.And therefore, no transaction, andtherefore, no attendant transactions costs

would be necessary in order to move thoseproperty rights from the lower valuingowner until the higher valuing owner.And so Posner, in this case, would agreewith Holmes by saying, if transactionscosts created by the holdup problem are solarge that the transactions that would benecessary to move property rights from thelower valuing LeRoys to the higher valuingrailway would not be undertaken, thenefficient allocation can only be realized.If the court grants the relevant propertyright to throw sparks into the near area

of LeRoy's yard to the railroad.Of course, as I've suggested, this assumesthat the court knows that the railroad isthe higher valuing owner.And that's something it can only determinein terms of the evidence which ispresented to it in court.So, all of this suggests that efficiencycan be achieved by an appropriate decisionby the court.Though this decision, to realizeefficiency, in this case, will have beenmade at the expense not just of one LeRoy,

but of every LeRoy.That is to say, a new property right, theright to throw sparks from a carefullyoperated train into the near area of theLeRoys' yards, this new right would havebeen determined by Holmes' jury, andawarded to the railroad at the expense ofthe LeRoy companies.The railroad would be allowed to throwsparks.

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Without fear of liability, and the ray,the Leroys would be therefore required totake account of the railroads doing thisand reorganize their yards so as toaccount for the sparks, and thereby costthemselves some money.So, efficiency would be achieved by theapplication of Holmes' Posner's area inthis case.But it would be done perhaps at theexpense of justice if we believe thatjustice required that the railroad buy theright from the LeRoys.If we sympathize with the LeRoys, if wethink that justice requires that they havethe right to profit from the railroad'stossing of sparks in their yard, thenHolmes' rule would do an injustice.If, on the other hand, we believe thatjustice is not something that courts cando easily or fairly, that is that justicecan't be done in an unarbitrary way, thenefficiency provides a standard on whichall sides can agree if the court is

correct in determining who the highestvaluing property owner is.And so, Posner's corollary, as you cansee, has great practical significance inthe real world, where transactions costsare high.Where transactions costs are high, Posnershows, efficient allocation of propertyrights can only be achieved if the highervaluing owner is given the property rightsfor free in the initial allocation buy in.But this may do distributional injusticeby giving a property right to the higher

valuing owner for free.And thereby denying the lower valuingowner of the property right theopportunity to share in the profits, orthe value that will accrue to the highervaluing owner from that onwards possessionof the property right itself.In the next lecture, we'll talk aboutthese distributional concerns moreexplicitly in a case where transactionscosts are very low.