Reminder HW1 due noon Thursday via

Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 4

Reminder HW1 due noon Thursday via Learn@UW
If you want to read ahead for Wednesday: Harold Demsetz, “Toward a Theory of Property Rights”

Last week, we… Defined efficiency
Maximizing total surplus achieved by everyone in society… …with value measured by willingness-to-pay Asked whether efficiency is a good normative goal for a legal system Posner: yes, because ex ante (before we knew which part we would play), we’d all agree to efficient rules Cooter and Ulen: yes, because even if society has other goals in mind, such as redistribution, it’s better to make the law efficient and achieve redistribution through taxes Open discussion question What are other plausible normative goals for a legal system? When would you expect them to conflict with efficiency?

Some basic game theory 3 3

A brief introduction to game theory
Today, we focus on static games Also known as simultaneous-move games A static game is completely described by three things: Who the players are What actions are available to each player What payoff each player will get, as a function of his own action, and the actions of the other players Any complete description of these three things fully characterizes a static game We’ve already used a little bit of game theory in this class – in the fishing example we did on Monday Think about the logic of the fisherman we discussed “I don’t have any control over how much the rest of the village fishes; all I control is how much I fish.” “And what I’m going to do is decide how much I should fish, given what everyone else is doing, to maximize my own payoffs.” That’s exactly the logic of game theory. 4 4

A classic example: the Prisoner’s Dilemma
(Story) Players: player 1 and player 2 Two actions available to each player: rat on the other, or keep mum Payoffs: u1(mum, mum) = -1 u1(rat, mum) = 0 u1(mum, rat) = -10 u1(rat,rat) = -5 Same for player 2 (Story) Players: player 1 and player 2 Two actions available to each player: rat on the other, or keep mum Payoffs: If both keep quiet, both convicted of a lesser crime, both get payoffs of -1 (1 year in jail) If one rats, he goes free, his friend gets payoff of -10 (10 years in jail) If both rat, both are convicted, each gets -5 So u1(mum, mum) = -1, u1(rat, mum) = 0, u1(mum, rat) = -10, u1(rat,rat) = -5 And player 2’s are similar 5 5

In two-player games with finite actions, one way to present game is payoff matrix
Always Player 1 Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 Rat Player 1’s Payoff Player 2’s Payoff 6 6

Nash Equilibrium We solve a game by looking for a Nash equilibrium
Nash equilibrium is a strategy profile (an action for each player) such that: No player can improve his payoff by switching to a different action… …given what his opponent/opponents are doing In most games, players won’t have a single move that’s always best Best move will sometimes depend on what other player (or players) is doing We solve a game by looking for a Nash equilibrium Nash equilibrium is a strategy profile (an action for each player) such that no one player can do better by switching to a different action (given what everyone else is doing) So playing Mum is never part of an equilibrium Whatever your opponent is doing, you could improve by switching to Rat 7 7

A strategy profile is a Nash Equilibrium if no player can gain by deviating
If any player can improve his payoff by changing his action, given his opponents’ actions, then it is not a Nash equilibrium Is (Mum, Mum) an equilibrium? No, if player 2 is playing Mum player 1 gains by deviating Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 Rat 8 8

In two-player games, we find Nash equilibria by highlighting best responses
My best response to a particular play by the other player is whichever action(s) give me the highest payoff To find Nash Equilibria… Circle payoff from player 1’s best response to each action by his opponent Circle payoff from player 2’s best response to each action Any box with both payoffs circled is an equilibrium Because each player is playing a best-response to his opponent’s action… …so neither one can improve by changing his strategy Player 2’s Action Mum Rat -1, -1 -10, 0 Mum Player 1’s Action 0, -10 -5, -5 In the Prisoner’s Dilemma game, (Rat, Rat), or “Both players play Rat”, is the only Nash equilibrium Hence the name – only equilibrium is for both to Rat, but both would do better if both kept Mum Rat 9 9

Some games will have more than one equilibrium
Another classic: Battle of the Sexes (Story) Circle player 1’s best responses Circle player 2’s best responses We find two equilibria: (ballgame, ballgame) and (opera, opera) Game theory usually doesn’t have that much to say about which equilibrium will get played when there are more than one Player 2’s Action Baseball Game Opera 6, 3 0, 0 Baseball Game Player 1’s Action 0, 0 3, 6 Opera 10 10

Sometimes, there will be a “good” and a “bad” equilibrium
Growth model (Story) Circle player 1’s best responses Circle player 2’s best responses Two equilibria: (invest, invest) and (consume, consume) Some papers explain differences in growth across countries by saying some are in “good” equilibrium and some are in “bad” one Player 2’s Action Invest Consume 2, 2 0, 1 Invest Player 1’s Action 1, 0 1, 1 Consume 11 11

Some games don’t have any equilibrium where players only play one action
Scissors, Paper, Rock for $1 Look for Nash Equilibria by circling best responses No square with both payoffs circled No equilibrium where each player plays a single action In this class, we’ll focus on games with a pure-strategy Nash equilibrium Player 2’s Action Scissors Paper Rock 0, 0 1, -1 -1, 1 Scissors -1, 1 0, 0 1, -1 Player 1’s Action Paper 1, -1 -1, 1 0, 0 Rock 12 12

That’s a very quick introduction to static games
Now on to… 13 13

Property Law 14 14

Why do we need property law in the first place?
We already saw one reason Tragedy of Commons – overuse of land is held in common For another example, imagine two neighboring farmers Each has two choices: farm his own land, or steal crops from his neighbor Stealing is less efficient than planting my own crops Have to carry the crops from your land to mine Might drop some along the way Have to steal at night  move slower If I steal your crops, I avoid the effort of planting and watering Once we have property, we’ll inevitably have some amount of property conflicts But why do we need private property in the first place? We’ve already seen one reason why we might want private property: the Tragedy of the Commons example from Monday 15 15

Why do we need property law in the first place?
Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3 With no legal system, the game has the following payoffs: We look for equilibrium Like Prisoner’s Dilemma both farmers stealing is the only equilibrium but that outcome is Pareto-dominated by both farmers farming Player 2 Farm Steal 10, 10 -5, 12 Farm Player 1 12, -5 0, 0 Steal 16 16

So how do we fix the problem?
Suppose there were lots of farmers facing this same problem They come up with an idea: Institute some property rights And some type of government that would punish people who steal Setting up the system would cost something Suppose it imposes a cost c on everyone who plays by the rules 17 17

So how do we fix the problem?
ORIGINAL GAME MODIFIED GAME Player 2 Player 2 Farm Steal Farm Steal 10, 10 -5, 12 10 – c, 10 – c -5 – c, 12 – P Farm Farm Player 1 Player 1 12, -5 0, 0 12 – P, -5 – c -P, -P Steal Steal If P is big, and c is not too big, then 12 – P < 10 – c In that case, (Farm, Farm) is an equilibrium Payoffs are (10 – c, 10 – c), instead of (0, 0) from before 18 18

So the idea here… Anarchy is inefficient
I spend time and effort stealing from you You spend time and effort defending your property from thieves Instead of doing productive work Establishing property rights, and a legal process for when they’re violated, is one way around the problem Keep in mind, though, that there is still inefficiency here – the cost c of administering the system That is, payoffs of (10-c, 10-c) are better than payoffs of (0,0), but not as good as (10,10) 19 19

But once we have property rights, yours will sometimes conflict with mine
I buy a house out in the countryside. This is my neighbor. Here’s the property line – the line separating his land from mine. One summer, I put in a pool. The next year, my neighbor plants a bunch of new trees along the property line… …and now, in the late afternoon, my pool is completely shaded. I go to my neighbor and ask him to cut down the trees, as they’re ruining my swimming pool And he says they’re on his land, and he likes them, so they stay. Who’s right? 20 20

Overview of Property Law
Cooter and Ulen: property is “A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” Property rights are not absolute Appendix to ch. 4 discusses different conceptions of property rights Any system has to answer four fundamental questions: What things can be privately owned? What can (and can’t) an owner do with his property? How are property rights established? What remedies are given when property rights are violated? Cooter and Ulen define property as “a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others.” Of course, property rights aren’t absolute. In the appendix to chapter 4, they give examples of different conceptions of property rights. Without getting into the philosophy behind a property rights system, it’s clear that a conception of property rights has to answer four fundamental questions: What things can be privately owned? Clearly not everything can be owned – nobody owns the ocean, can’t own another person, etc. Ancient Jewish law – ownership over sold land was not permanent, it reverted to its ancestral owner after 50 years Cultural artifacts; Intangible property – copyrights, patents, trademarks What can (and can’t) an owner do with his property? Again, not everything - property rights can’t be absolute, because my exercising my rights might interfere with you exercising your rights – I want to sleep, you want to have a party next door Typically, you can’t use your own property in a way that creates a nuisance to others Many of the examples when we discuss Coase will have to do with limiting what a person can do with his property. I own my kidneys, but I can’t sell one If I own a building that has historical significance, I can’t necessarily destroy it or change it in certain ways. How are property rights established? In the whaling example, what does it take to establish ownership? In many cases when government wanted to encourage migration into new areas, free land, conditional on you farming it or developing it. And on the flip side, when can property rights be revoked? Eminent domain – the government’s right to seize private property Negligent landlords. What remedies are given when property rights are violated? Rights – my right to use my property in certain ways – and prohibitions – other people can’t interfere – have no meaning unless they are enforced So how do I get compensated if my property rights are violated? 21 21

Answers to many of these seem obvious
BUT… You’re marketing my leg! Amputee, opportunist wrangle over custody of limb left in barbecue smoker updated 10/2/2007 4:50:12 PM ET T20:50:12 MAIDEN, N.C. — A South Carolina man who stored his severed leg in a barbecue smoker that was later auctioned off is locked in a custody dispute with the North Carolina man who found it. John Wood's leg was amputated near the knee after a 2004 airplane crash. He asked doctors to give it to him so he could be buried as a whole man when he died. The limb, which Wood had kept in the smoker in a storage facility after he lost his home, was bought by Shannon Whisnant last Tuesday in an auction held by the storage company because Wood had missed his monthly payments. Whisnant initially gave it to police, who subsequently turned it over to a funeral home when it became clear it was not the result of foul play. But Whisnant, who put a sign on the empty smoker charging adults $3 and children $1 for a look, now wants the leg back. "He's making a freak show out of it," Wood told The Charlotte Observer for a Monday story. "He wants to put money in his pocket with this thing." Whisnant, who was unsuccessful in his bid to get the leg from the funeral home, consulted with a lawyer and decided his best move was to persuade Wood to share custody and profits. "It's a strange incident, and Halloween's just around the corner," Whisnant said. "The price will be going up if I get (a stake in) the leg." Wood, who is heading to Maiden to pick up his leg, said the two men can meet, but he is not interested in using the leg to make money. "I just think it's despicable," he said. "I don't mind having the 15 minutes of fame, but I'm not looking to really profit off this thing." © 2012 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed. source: What’s my point? Not that it matters much who ended up with ownership of a guy’s severed leg. (Matters a lot to Wood, a little to Whisnant, they had their 15 minutes.) My point is that even if most things in property law seem obvious – this is my iPhone, you can’t steal it, I can use it however I want – the law has to deal with the unexpected, off-the-wall cases as well as the anticipated, obvious ones So we’d better try to come up with some principles we want our property law system to satisfy, so we know how to deal with the unexpected (In 2007, after the case got some media attention, Whisnant and Wood ended up going on Judge Mathis, who awarded the leg back to its original owner.) source: 22 22

How do we design property law to achieve efficient outcomes?
What’s my point? Not that it matters much who ended up with ownership of a guy’s severed leg. (Matters a lot to Wood, a little to Whisnant, they had their 15 minutes.) My point is that even if most things in property law seem obvious – this is my iPhone, you can’t steal it, I can use it however I want – the law has to deal with the unexpected, off-the-wall cases as well as the anticipated, obvious ones So we’d better try to come up with some principles we want our property law system to satisfy, so we know how to deal with the unexpected (In 2007, after the case got some media attention, Whisnant and Wood ended up going on Judge Mathis, who awarded the leg back to its original owner.) And so that becomes the question for us: what general principles do we want our property law system to adhere to? And in particular, how should we design it if we’re concerned with achieving efficient outcomes? 23 23

Coase The decision and dissent in Pierson v Post certainly suggest that how property law is designed will matter for efficiency So we come back to the question: how should property law be designed to achieve this goal?

How should property rights be allocated to achieve efficiency?
Coase’s surprising answer: it doesn’t matter (Under certain conditions)

The Coase Theorem Ronald Coase (1960), “The Problem of Social Cost”
In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency. It doesn’t matter how rights are allocated initially… …because if they’re allocated inefficiently at first, they can always be sold/traded… so the allocation will end up efficient anyway Initial allocation does matter for distribution, though And if there are transaction costs, may matter for efficiency too Ronald Coase

Example of Coase: you have a car worth $3,000 to you, $4,000 to me
Obviously, efficient for me to own it… …but we don’t need the law to give me the car If I start out owning the car: no reason for you to buy it, I end up with it  efficient If you start out owning the car: clear incentive for me to buy it, I end up with it  efficient Regardless of who owns the car at first, we get to the efficient outcome I’d rather start out with the car – so I don’t have to pay you for it You’d rather start out with it – so you end up with more money Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. And that doesn’t depend on who starts with it. The key: lack of transaction costs This is easiest to illustrate with an example we’ve already seen: your car. Since the car’s worth more to me than it is to you, we know it’s efficient for me to have the car. (Assume there are no externalities – my neighbors don’t care.) But it turns out, in order to achieve that outcome, we don’t need a law that says I get your car – all we need is for people to be allowed to buy and sell used cars. Why? If I start off with the car, then great – I have the car, there’s no reason for you to buy it from me, I keep the car, and we get efficiency. If you start off with the car, then we clearly have an incentive to come to some arrangement. Property rights have to be well-defined – it has to be clear that it’s your car, and you have to be allowed to sell it to me. But as long as that’s the case, we should be able to reach some bargain – I give you $3,500, or maybe a bit more, or maybe a bit less – and you give me the car. So I end up with the car, which is efficient. The point is, regardless of who starts off with the car, I’m going to end up with it. I’d rather I start with the car – that way, I don’t have to pay you anything. You’d rather you start with the car – that way, you end up with a bunch of my money. But for efficiency, it doesn’t matter who starts with the car - we’ll achieve efficiency (me having the car) either way. The key here is the absence of transaction costs. Basically, there can’t be any impediments to us reaching a private agreement If every time someone sold a used car, the buyer had to pay a huge tax to the government, the Coase theorem would fail We saw a few examples Tuesday of forces that lead to inefficiency – barriers to trade, taxes. These can be thought of as transaction costs. Next lecture, we’ll discuss what some sources of transaction costs are; for now, just think of them as anything that gets in the way of us trading among ourselves.

Another example: you want to have a party in the house next door to mine
If it’s efficient for you to have the party… Your benefit from having the party is greater than my benefit from a good night’s sleep If you start out with the right to have the party, no problem If I start out with the right to quiet, you can pay me for the right to have the party If it’s efficient for you not to have the party… Good night sleep is worth more to me If I have right to silence, no problem If you have right to party, I can pay you not to have it The point: either way, we achieve efficiency If it’s efficient to have the party, you have the party If it’s efficient not to, you don’t Regardless of who started off with the right The Coase theorem sounds pretty obvious when it comes to objects. If you own something, but it’s worth more to me, and there’s nothing to stop you from selling it to me, I guess you’ll end up selling it to me. Obviously. What Coase did, though, was apply this to rights, and situations with externalities, as well. I have an apartment, and you live next door, and you want to have a party on Saturday I hate noise, and don’t want you to. Should you be allowed to have the party? The point of Coase: think of the right to have the party (or to prevent it) as just another object If it’s efficient for you to have the party, that means the party is worth more to you and your guests than a good night’s sleep is worth to me Which means the “party rights” are worth more to you than they are to me If you start out with them, great If I start out with them – if the law gives me the power to prevent you from making noise – you can buy the rights from me. That is, you can pay me to allow you to have the party. And if it really is efficient for you to have the party, you and your guests can come up with enough money to buy me off, and still be better off yourselves. What if sleep is worth more to me than the party is to you? That means it’s not efficient to have the party. If I start out with the right to peace and quiet, we don’t need to do anything But if you start out with the right to have a party, I can bribe you not to. Again, for distribution, who starts off with the rights matters – since they’re worth something, we’d both rather have them But who starts off with them doesn’t matter for efficiency – we’ll get to efficiency either way

The conditions for this to hold
Property rights have to be well-defined… We need to be clear on who has what rights, so we know the starting point for negotiations …and tradable… We need to be allowed to sell/transfer/reallocate rights if we want …and there can’t be transaction costs It can’t be difficult or costly for us to buy/sell the right

Coase’s example: a rancher and a farmer
Coase doesn’t actually write about neighbors and parties - he starts with a different example Suppose that on adjacent tracts of land, there is a cattle rancher and a farmer The rancher has cows, the farmer grows some crop – say, corn And on occasion, the rancher’s cattle will occasionally stray onto the farmer’s land and eat some of the crops So we need a rule for who’s responsible for the damage when that happens

Rancher’s versus farmer’s rights
English common law: “closed range” or “fencing-in” (or “farmer’s rights”) Ranchers have responsibility to control their cattle Rancher must pay for any damage done by his herd Much of the U.S. at various times: “open range” or “fencing-out” (or “rancher’s rights”) Rancher can let his cattle roam free Not liable for damage they do to farmer’s crops (unless farmer had a good fence and they broke through anyway) Which rule is more efficient? There are two obvious candidates for what the law could be: either the rancher is responsible for the damage his cattle did, or he isn’t

Open range versus closed range
First, let’s consider what happens under an open range law – that is, when the rancher is not liable for damage done by his herd When the rancher is deciding on the size of his herd, he weighs only the private costs and benefits, ignoring the incremental damage that a larger herd would do to his neighbor’s crops – that is, ignoring the externality he imposes So on the margin, this may lead him to a cattle herd that’s inefficiently large In addition, since he isn’t harmed by the damage done by his herd, he has no incentive to build a fence or to do anything else to rein in his herd But the farmer, faced with the prospect of damage, has a clear incentive to take any steps he can to reduce the damage – such as building a fence around his crops to keep out wandering cattle planting less planting less along the boundary between the two tracts of land or planting crops that cows don’t like along the boundary or any other steps that might also be cheaper than the damage done. Next, consider what happens under a closed range law – when the rancher is liable for any damage done by his herd Now the farmer has no reason to build a fence, or to take any other action When the rancher is deciding how big a herd to keep, he will consider the incremental damage done to his neighbor, since he has to pay for the damage; and he will consider actions that he can take to restrain his herd, like fencing in the grazing land, if that’s cheaper than paying for the damage

Coase: either law will lead to efficiency
If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd… Under open range law, that’s what he’ll do Under closed range law, rancher can pay farmer to build fence If smaller herd is more efficient, farmer can pay rancher to keep fewer cattle Coase: Whatever is the efficient combination of cattle, crops, fences, etc.… …the rancher and farmer will negotiate to that efficient outcome, regardless of which law is in place… …as long as the rights are well-defined and tradable and there are no transaction costs Coase, however, comes along, and says it doesn’t matter which law is in place – either one will lead to the same, efficient outcome If it’s cheaper for the farmer to fence in his crops, rather than the rancher fencing in his herd… Under an open range law, that will happen automatically Under a closed range law, rather than fencing in his herd, the rancher will pay the farmer to build a fence around his crops If it’s efficient for the rancher to keep a smaller herd, the farmer can pay the rancher to do so Coase’s conclusion: whatever is the most efficient combination of cattle, crops, fences, and so on, is exactly what will happen, because the rancher and farmer will negotiate to that outcome to save money Just as long as his assumptions are satisfied – property rights are well-defined and tradable, and there are no transaction costs

Note that there’s no sense of “blame” here
Pigovian tax (Arthur Pigou) Penalize firms for causing negative externalities Requires us to “blame” one party Coase: doesn’t matter who is “causing” the harm “It is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops.” Coase isn’t worried about “justice”, just efficiency Doesn’t matter if a polluter is actually charged for polluting… …or is allowed to pollute, but could be bribed to not pollute Either way, without transaction costs, we’ll end up getting the efficient amount of pollution!

Rancher and farmer: numerical example
Three possibilities: Rancher builds fence around herd… costs $400 Farmer builds fence around crops… costs $200 Do nothing, live with damage… costs nothing If expected crop damage = $100 Open range: farmer lives with damage rather than building fence Closed range: rancher pays for damage rather than fence If expected crop damage = $500 Open range: farmer builds fence – efficient Coase: closed range: rancher pays farmer to build fence So efficient outcome under either rule To be more specific… Suppose there are three things that could be done about the problem: The rancher could build a fence to restrain his herd – suppose this costs $400 The farmer could build a fence to protect his crops – suppose this costs $200 Finally, they could both just do nothing, and live with the damage Now, if the damage the cattle will do is less than $200, there’s no reason to do anything Suppose the damage is only $100 it’s inefficient to build a fence – it costs more than the problem it solves in a rancher’s rights world – where the rancher is not liable for damage done by his herd – the farmer won’t choose to build a fence, he’ll just eat the $100 loss in a farmer’s rights world – where the rancher is liable – he’ll just live with paying the farmer $100 to reimburse him for the damage On the other hand, suppose the damage the cattle will do is more than $200 suppose it’s $500 then the efficient thing is for the farmer to build a fence in a rancher’s-rights world, this will happen “automatically” – the farmer would rather build a $200 fence than suffer $500 of unreimbursed damages the point of Coase: in a farmer’s-rights world, this is also what will happen – because the rancher will pay the farmer to build a fence that is, rather than face paying $500 for the damage done, and rather than spend $400 to build his own fence, he will offer the farmer some smaller amount – say, $300 – to put up a fence and the farmer will prefer that to doing nothing

Other examples from Coase
Lots of examples from case law a building that blocked air currents from turning a windmill a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door a doctor next door to a confectioner a chemical manufacturer a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation Coase gives a number of examples of specific cases in nuisance law, and repeats the point that, regardless of who is initially held responsible for the harm, negotiation and trade will lead to efficiency from any starting point Some of his other examples: An early English case of a building which was built in such a way that it blocked air currents from turning a windmill A building in Florida which cast a shadow over the swimming pool and sunbathing areas of a nearby hotel A doctor whose office was next door to a confectioner, who built a new examination room and found that the vibration from the confectionery’s machinery prevented him from listening to his patients’ chests through a stethoscope in that room A chemical manufacturer whose fumes interacted with a weaver’s products while they were drying after bleaching A house whose chimney no longer worked well after its neighbors rebuilt their house to be taller In each example, he argues that, regardless of who is held to be liable, the parties can negotiate with each other and take whatever remedy is cheapest to fix (or endure) the situation.

Quoting from Coase (p. 13):
Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved. In the case of the cattle and the crops, it is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops. The doctor’s work would not have been disturbed if the confectioner had not worked his machinery; but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place… This is an important point – Coase points out, we shouldn’t think of the problem as, “Should the rancher be allowed to harm the farmer?”, since that begs the question. Instead, we should ask the question, “Either the rancher harms the farmer, or the farmer harms the rancher; which of these situations is the more efficient?”

Quoting from Coase (p. 13):
If we are to discuss the problem in terms of causation, both parties cause the damage. If we are to attain an optimum allocation of resources, it is therefore desirable that both parties should take the harmful effects into account when deciding on their course of action. It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties. That is, both parties perceive the cost of the externality, at least as an opportunity cost.

What does Coase mean by “a cost for both parties”?
If the cheapest alternative is for the farmer to build a fence for $200… The cost to build a fence is $200 But the cost to not build a fence is more than $200 – since under a closed-range law, the farmer could ask the rancher for more than $200 to build the fence “Opportunity cost” This last part is a little subtle. But go back to our rancher-farmer example. The rancher’s cattle are doing $500 worth of damage, and the cheapest way to fix it is for the farmer to build a fence for $200 consider the farmer’s-rights world the farmer doesn’t have to build a fence – the rancher will have to build his own fence, or pay for the damage but even though he doesn’t have to build a fence, the farmer perceives the cost of not building the fence as higher than the cost of building it this is because he faces an opportunity cost the cost of building the fence is $200 the cost of not building the fence is the foregone opportunity to get the rancher to pay him MORE THAN $200 to build it If I’m causing $100 of damage to my neighbor but I could prevent it for $10, a “smoothly operating pricing system” causes me to view the cost of the externality as $100 in opportunity cost – since I could presumably get my neighbor to pay me that much money to prevent the damage.

So, summing up… Coase Theorem: In the absence of transaction costs,
if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency. The initial allocation of property rights therefore does not matter for achieving efficiency… …provided there are no transaction costs (But if there are transaction costs, then the initial allocation can matter for efficiency… …and it will always matter for distribution) So that’s the Coase Theorem Of course, the limitations we mentioned still hold: First, Coase says that the initial allocation of rights (or liability) does not matter for efficiency – but as we said, it does matter for distribution And second, all of this only works in the absence of any transaction costs – which may not be the case in the real world (we’ll come back to transaction costs in a bit)

One early, “classic” property law case
Pierson v. Post (NY Supreme Court, 1805) Lodowick Post organized a fox hunt, was chasing a fox Jesse Pierson appeared “out of nowhere,” killed the fox and took it Post sued to get the fox back Lower court sided with Post; Pierson appealed to NY Supreme Court Question: when do you own an animal? I mention it here not because we care that much about when you establish possession of a wild animal, but because the court – both the majority and the dissenting opinion – were explicit about considering the economic effects their ruling would lead to 42 42

One early, “classic” property law case
Court ruled for Pierson (the one who killed the fox) “If the first seeing, starting, or pursuing such animals… should afford the basis of actions against others for intercepting and killing them, it would prove a fertile source of quarrels and litigation” (Also: just because an action is “uncourteous or unkind” does not make it illegal) Dissenting opinion: a fox is a “wild and noxious beast,” and killing foxes is “meritorious and of public benefit” Post should own the fox, in order to encourage fox hunting That is, if the first to chase an animal owned it, there would be endless disputes and court cases; and so they favored a more “bright line” rule of ownership which would lead to fewer disagreements 43 43

Same tradeoff we saw earlier:
Pierson gets the fox simpler rule (finders keepers) easier to implement fewer disputes Post gets the fox more efficient incentives (stronger incentive to pursue animals that may be hard to catch) Just like Fast Fish/Loose Fish vs Iron Holds The Whale Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes Iron Holds the Whale is more complicated, but is necessary with whales where hunting them the old-fashioned way is too dangerous 44 44

Doesn’t Coase make Pierson v Post irrelevant?
Coase seems to say: for efficiency, it doesn’t matter who starts off with the right to the fox If Post values it more, he can buy it from Pierson, or vice versa Seems to imply: one rule is just as good as the other, as long as we all know what the rule is So why does Pierson v Post matter? Transaction costs! Majority: if Post gets the fox back, “it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly Dissent: killing foxes is a good thing (externality), so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining We started today’s lecture talking about Pierson v Post, the fox hunt case Both the majority and the dissenting opinion seemed to imply the ruling mattered for efficiency Majority wanted to reduce the number of fox cases that ended up in court Dissent wanted to get more people to hunt foxes But we just saw the Coase theorem, which says that the initial allocation of rights shouldn’t matter for efficiency As long as we all know what the rule is, and can bargain around it, any rule is just as good as another So why doesn’t Coase make the actual ruling irrelevant? The Coase Theorem required a complete absence of transaction costs But in the real world, there sometimes are transaction costs The situation the Pierson court was concerned with – lots of lawsuits in the future – is exactly a transaction cost If we allow ownership based on “I saw the fox first”, people will constantly be suing each other for foxes… …and those lawsuits waste time and money! The situation the dissent was concerned with – not enough foxes being hunted – is also related to transaction costs They write that killing foxes is of public benefit – that it has an externality This means that lots of people are affected by someone’s decision to hunt foxes But as we’ll discuss Wednesday, bargaining is very difficult – and/or costly – when lots of people are involved So it may be very hard to achieve the efficient level of fox hunting through negotiations! Coase says, in situations with no transaction costs, the initial allocation of rights doesn’t affect efficiency But lots of real-world situations do indeed have transaction costs

Transaction costs Coase: “in the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.” This suggests that if there are transaction costs, voluntary negotiations may not lead to efficiency Car example (yet again) If transactions are costly, we may not trade And if we do trade, we incur that cost Recall our statement of the Coase Theorem: In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency, and the initial allocation of property rights won’t matter for efficiency. But this also suggests the converse might be true: when private negotiations are not costless, or transaction costs are not zero, that we may not get efficiency, and initial allocations may matter. When there are transaction costs, we can get inefficiencies for two reasons: first, when transaction costs are high, they will prevent certain trades that would have been beneficial if your car is worth $3,000 to you and $4,000 to you, but it would cost us $2,000 to find each other and transact, you’ll keep the car and second, any resources actually spent overcoming the transaction costs are, in a sense, wasted if it costs us $500 to find each other and transact, we’ll still do it, but we will have lost that $500

Quoting Coase… “If market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast. But… the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law. In such cases, the courts directly influence economic activity. …Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out.

We can see the Coase Theorem as either a positive or negative result
“In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.” We can read this as… “As long as transaction costs aren’t a big deal, we’ll get efficiency” Or as, “we’ll only get efficiency automatically if there are no transaction costs” Coase also gives two examples of institutions that may emerge in response to high transaction costs: Firms Government regulation Coase offers two examples of institutions that may emerge in response to high transaction costs: firms, and government regulation Suppose it is very difficult or costly for the rancher and the farmer to come to an agreement among themselves. One solution is for the ranch and the farmland to be both be purchased and operated by the same firm. Then the firm balances the costs and benefits of both activities, and makes decisions (what fence to build, how big a herd to raise) to maximize the total value of production The second example, government regulation, is the same idea, since he imagines the government as a sort of “super-firm” which considers the costs and benefits of each activity to everyone.

Many externalities can be thought of as missing property rights
Overfishing in communal lake? It’s because property rights over those fish aren’t well-defined Firm polluting too much? It’s because property rights over clean air aren’t well-defined So one solution… Make property rights complete enough to cover “everything,” and tradable, and use the law to minimize transaction costs… …Then Coase kicks in and we get efficiency! (Booya!) So why not do this? COSTS!

That’s it for today HW1 due (online submission) noon Thursday
For Wednesday Demsetz, “Toward a Theory of Property Rights”

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