econ 522 economics of law dan quint fall 2012 lecture 5

Econ 522Economics of Law

Dan Quint

Fall 2012

Lecture 5

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Coase Theorem: in the absence of transaction costs,if property rights are well-defined and tradable, we’ll always get efficiency Or: if conditions are perfect, initial allocation of rights doesn’t matter

for efficiency Or, if property rights are complete enough, we can overcome

externalities

Two important caveats we’ll talk about today More expansive property rights are more costly to

implement/enforce – need to make sure it’s worth it Coase only applies when no transaction costs – but when is that a

good assumption?

Last week…

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When are stronger property rights “worth it”?

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We motivated property law by looking at a game between two neighboring farmers

10 – c, 10 – c -5 – c, 12 – P

12 – P, -5 – c -P, -P

Farm Steal

Farm

Steal

Player 2

Pla

yer

110, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

Pla

yer

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MODIFIED GAMEORIGINAL GAME

Changing the game had two effects: Allowed us to cooperate by not stealing from each other Introduced a cost c of administering a property rights system

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“A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities”

“[ In order for an externality to persist, ] The cost of a transaction in the rights between the parties… must exceed the gains from internalization.”

“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”

Harold Demsetz (1967), “Toward a Theory of Property Rights”

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Private ownership of land among Native Americans Cost of administering private ownership: moderate Before fur trade…

externality was small, so gains from internalization were small gains < costs no private ownership of land


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Private ownership of land among Native Americans Cost of administering private ownership: moderate Before fur trade…

externality was small, so gains from internalization were small gains < costs no private ownership of land

As fur trading developed… externality grew, so gains from internalization grew gains > costs private property rights developed


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The date is 10,000 or 11,000 B.C. You are a member of a primitive tribe that farms its land in common. Farming land in common is a pain; you spend almost as much time watching each other and arguing about who is or is not doing his share as you do scratching the ground with pointed sticks and pulling weeds.

…It has occurred to several of you that the problem would disappear if you converted the common land to private property. Each person would farm his own land; if your neighbor chose not to work very hard, it would be he and his children, not you and yours, that would go hungry.

Friedman tells a similar story: “we owe civilization to the dogs”

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There is a problem with this solution… Private property does not enforce itself. Someone has to make sure that the lazy neighbor doesn’t solve his food shortage at your expense.

[Now] you will have to spend your nights making sure they are not working hard harvesting your fields. All things considered, you conclude that communal farming is the least bad solution.


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Agricultural land continues to be treated as a commons for another thousand years, until somebody makes a radical technological innovation: the domestication of the dog.

Dogs, being territorial animals, can be taught to identify their owner’s property as their territory and respond appropriately to trespassers. Now you can convert to private property in agricultural land and sleep soundly. Think of it as the bionic burglar alarm.

-Friedman, Law’s Order, p. 118


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Coase: if property rights are complete and tradable, we’ll always get efficiency

Demsetz: yes, but this comes at a cost property rights will expand when the benefits outweigh the costs either because the benefits rise… …or because the costs fall

Of course, Coase wasn’t completely ignoring costs… Next: what are transaction costs, how do we deal with them?

So…

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TransactionCosts

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Anything that makes it difficult or expensive for two parties to achieve a mutually beneficial trade

Three categories Search costs – difficulty in finding a trading partner Bargaining costs – difficulty in reaching an agreement Enforcement costs – difficulty in enforcing the agreement

afterwards

What are transaction costs?

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Asymmetric information Akerloff (1970), “The Market for Lemons” – adverse selection

Bargaining costs come in many forms

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Private information (don’t know each others’ threat points) Myerson and Satterthwaite (1983), “Efficient Mechanisms for

Bilateral Trading” – always some chance of inefficiency


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Private information (don’t know each others’ threat points) Myerson and Satterthwaite (1983), “Efficient Mechanisms for

Bilateral Trading” – always some chance of inefficiency

Uncertainty If property rights are ambiguous, threat points are uncertain, and

bargaining is difficult


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Large numbers of parties Developer values large area of land at $1,000,000 10 homeowners, each value their plot at $80,000


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Large numbers of parties Developer values large area of land at $1,000,000 10 homeowners, each value their plot at $80,000 Holdout, freeriding

Hostility


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Example of high transaction costs with many sellers

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Search costs

Bargaining costs Asymmetric information/adverse selection Private information/not knowing each others’ threat points Uncertainty about property rights/threat points Large numbers of buyers/sellers – holdout, freeriding Hostility

Enforcement costs

Sources of transaction costs

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So, whatdo we do?

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No transaction costs initial allocation of rights doesn’t matter for efficiency wherever they start, people will trade until efficiency is achieved

Significant transaction costs initial allocation does matter, since trade may not occur (and is costly if it does)

This leads to two normative approaches we could take

What we know so far…

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Design the law to minimize transaction costs “Structure the law so as to remove the impediments to private

agreements” Normative Coase “Lubricate” bargaining

Two normative approaches to property law

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Design the law to minimize transaction costs “Structure the law so as to remove the impediments to private

agreements” Normative Coase “Lubricate” bargaining

Try to allocate rights efficiently to start with, so bargaining doesn’t matter that much “Structure the law so as to minimize the harm caused by failures

in private agreements” Normative Hobbes

Two normative approaches to property law

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Compare cost of each approach Normative Coase: cost of transacting, and remaining inefficiencies Normative Hobbes: cost of figuring out how to allocate rights

efficiently (information costs)

When transaction costs are low and information costs are high, structure the law so as to minimize transaction costs

When transaction costs are high and information costs are low, structure the law to allocate property rights to whoever values them the most

Which approach should we use?

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When transaction costs are low, design the law to facilitate voluntary trade

When transaction costs are high, design the law to allocate rights efficiently whenever possible

So now we have one general principle we can use for designing property law

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Designing an efficient property law system

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what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

Four questions we need to answer

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Public versus Private Goods

Private Goods

rivalrous – one’s consumption precludes another

excludable – technologically possible to prevent consumption

example: apple

Public Goods

non-rivalrous

non-excludable

examples defense against nuclear

attack infrastructure (roads, bridges) parks, clean air, large

fireworks displays

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When private goods are owned publicly, they tend to be overutilized/overexploited


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When public goods are privately owned, they tend to be underprovided/undersupplied


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Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated


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Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated


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Transaction costs low facilitate voluntary trade Private goods – low transaction costs Private ownership facilitates trade

Transaction costs high allocate rights efficiently Public goods – high transaction costs Public provision/regulation of public goods required to get efficient

amount

This accords with the principle we just saw

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Four questions we need to answer

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Calabresi and Melamed (1972), Property Rules, Liability Rules, and Inalienability: One View of the Cathedral

Liability Is the rancher liable for the damage done by his herd?

Property Does the farmer’s right to his property include the right to be free

from trespassing cows?

Entitlements Is the farmer entitled to land free from trespassing animals? Or is the rancher entitled to the natural actions of his cattle?

Calabresi and Melamed treat property and liability under a common framework

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Three possible ways to protect an entitlement

Property rule / injunctive relief Violation of my entitlement is punished as a crime (Injunction: court order clarifying a right and specifically barring any

future violation) But entitlement is negotiable (I can choose to sell/give up my right)

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Three possible ways to protect an entitlement

Property rule / injunctive relief Violation of my entitlement is punished as a crime (Injunction: court order clarifying a right and specifically barring any future

violation) But entitlement is negotiable (I can choose to sell/give up my right)

Liability rule / damages Violations of my entitlement are compensated Damages – payment to victim to compensate for damage done

Inalienability Violations punished as a crime Unlike property rule, the entitlement cannot be sold

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Injuree (person whose entitlement is violated) always prefers a property rule

Injurer always prefers a damages rule

Why? Punishment for violating a property rule is severe If the two sides need to negotiate to trade the right, injurer’s threat

point is lower Even if both rules eventually lead to the same outcome, injurer may

have to pay more

Comparing property/injunctive relief to liability/damages rule

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Electric company E emits smoke, dirties the laundry at a laundromat L next door

E earns profits of 1,000

Without smoke, L earns profits of 300

Smoke reduces L’s profits from 300 to 100

E could stop polluting at cost 500

L could prevent the damage at cost 100

Comparing injunctive relief todamages – example

E profits = 1,000L profits = 300 100E prevention = 500L prevention = 100

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Polluter’s Rights (no remedy) E earns 1,000 L installs filters, earns 300 – 100 = 200

Laundromat has right to damages E earns 1,000, pays damages of 200 800 L earns 100, gets damages of 200 300

Laundromat has right to injunction E installs scrubbers, earns 1,000 – 500 = 500 L earns 300

First, we consider thenon-cooperative outcomes


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Noncooperative payoffs

8001,1001,200Combined payoff (non-coop)

300300200L payoff(non-coop)

5008001,000E payoff(non-coop)

InjunctionDamagesPolluter’s Rights


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What about with bargaining?

1,2001,2001,200Combined

500350200L payoff (coop)

7008501,000E payoff (coop)

4001000Gains from Coop

8001,1001,200Combined payoff (non-coop)

300300200L payoff(non-coop)

5008001,000E payoff(non-coop)

InjunctionDamagesPolluter’s Rights


800 + ½ (100)

300 + ½ (100)

500 + ½ (400)

300 + ½ (400)

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Injunctions are generally cheaper to administer No need for court to calculate amount of harm done

Comparing injunctions to damages…

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Injunctions are generally cheaper to administer No need for court to calculate amount of harm done

Damages are generally more efficient when private bargaining is impossible Three possibilities: injurer prevents harm, injuree prevents harm,

nobody prevents harm (someone pays for it) Efficiency: cheapest of the three Damages: injurer can prevent harm or pay for it;

injurer chooses whichever is cheapest Injunction: injurer can only prevent harm

Comparing injunctions to damages…

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Any rule leads to efficient outcomes when TC are low

Injunctions are cheaper to implement

Damages lead to more efficient outcomes when TC high

Leads Calabresi and Melamed to the following conclusion:

When transaction costs are low, a property rule (injunctive relief) is more efficient

When transaction costs are high, a liability rule (damages) is more efficient

So now we know…

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“Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy.

On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.”

(Cooter and Ulen)

High transaction costs damagesLow transaction costs injunctive relief

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“When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely.

Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.”

(Cooter and Ulen)

A different view of the high-transaction-costs case…

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Cheaper for the court to administer With low transaction costs, we expect parties to negotiate

privately if the right is not assigned efficiently But… do they really?

Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral

20 nuisance cases: no bargaining after judgment

“In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining…

Frequently the parties were not on speaking terms...

…The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.”

Low transaction costs injunctive relief

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Inalienability: when an entitlement is not transferable or saleable

Allocative externalities(enriched uranium)

Third way to protect an entitlement: inalienability

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“Indirect” externalities(human organs)


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“Indirect” externalities(human organs)

Paternalism


source: http://www.shanghaidaily.com/nsp/National/2011/06/02/Boy%2Bregrets%2Bselling%2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/

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(we’ll probablyend here)

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Principle of maximum liberty

Owners can do whatever they like with their property, provided it does not interfere with other’ property or rights

That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else

What can an owner do with his property?

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What things can be privately owned? Private goods are privately owned, public goods are publicly

provided

What can owners do with their property? Maximum liberty

How are property rights established? (Examples to come)

What remedies are given? Injunctions when transaction costs are low; damages when

transaction costs are high

So, what does an efficient property law system look like?

econ 522 economics of law dan quint fall 2012 lecture 5

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