1. Econ 522 Economics of Law Dan Quint Fall 2015 Lecture 5

2. 1  No class on Wednesday (Yom Kippur)  G’mar Hatima Tovah  If you want to read ahead:  Guido Calabresi and Douglas Melamed, “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral” Reminders

3. 2  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  Basically, allow people to bargain, and they’ll bargain to efficiency Last week, we saw the Coase Theorem

4. 3 “There are two striking implications… that are true in a world of zero transaction costs. The output mix that results when the exchange of property rights is allowed is efficient, and the mix is independent of who is assigned ownership. For example, the the efficient mix of civilians and military will result from transferable ownership no matter whether taxpayers must hire military volunteers or whether draftees must pay taxpayers to be excused from service. For taxpayers will hire only those military (under the “buy-him-in” property right system) who would not pay to be exempted (under the “let-him-buy-his-way-out” system).” Nice interpretation/example from a paper we’re talking about today Harold Demsetz (1967), Toward A Theory of Property Rights

5. 4 Bargaining

6. 5 Let’s go back to our rancher and farmer Do nothing: $500 in crop damage

7. 6 Let’s go back to our rancher and farmer Rancher builds fence: $400 Farmer builds fence: $300

8. 7  Three possibilities  Nobody builds a fence – $500 in damage  Rancher builds fence – $400 cost  Farmer builds fence – $300 cost  Suppose we’re in a farmer’s rights world  Rancher is liable for any damage done by his herd  What does Coase predict will happen?  They’ll bargain to efficient outcome  Meaning, the farmer will build a fence (and the rancher will pay him)  How much will he pay? Let’s go back to our rancher and farmer No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

9. 8  Threat point – each side’s anticipated outcome if bargaining fails  “If we can’t agree to a deal and we go our separate ways, how well off am I?”  Negotiation textbooks call this your BATNA – “Best Alternative To a Negotiated Agreement”  Also called outside option, or reservation utility  Deal has to make everyone better off than that! Before bargaining: threat points No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

10. 9 Threat points What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point. What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point. No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

11. 10 Threat points What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

12. 11  So under a closed-range law…  The farmer’s threat point is 0, the rancher’s is –$400  Those are the payoffs that will happen if no agreement is reached  If a deal happens: total payoffs go up from –$400 to –$300  Farmer will build a fence (efficient outcome), rancher will pay him some money  Cooperation causes total payoffs to go up by $100  So $100 is gains from cooperation (or gains from trade) Gains from cooperation No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

13. 12  Coase predicts negotiation will lead to efficiency  So the gains from cooperation will be realized  (The farmer will build a fence)  Both sides have to do at least as well as their threat point  Otherwise, wouldn’t agree to deal  So rancher will pay farmer somewhere between $300 and $400 to build the fence  But what if we want a more precise prediction? So what will happen? No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

14. 13  What if gains from cooperation were split evenly?  Threat points 0 and –400, gains of 100  Farmer’s payoff: 0 + ½ (100) = 50  Rancher’s payoff: –400 + ½ (100) = –350  How is this achieved? Rancher pays farmer $350 to build fence So what will happen? No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

15. 14 If gains are split evenly… -300Combined Payoffs Farmer’s Payoff Rancher’s Payoff (IF…) 100Gains From Cooperation 0Farmer’s Threat Point -400Rancher’s Threat Point Farmer’s Rights –400 + ½ (100) 0 + ½ (100) = –350 = 50 No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

16. 15 If gains are split evenly… -300 Combined Payoffs 50-300Farmer’s Payoff -3500Rancher’s Payoff (IF…) 1000Gains From Cooperation 0-300Farmer’s Threat Point -4000Rancher’s Threat Point Farmer’s RightsRancher’s Rights =  No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights

17. 16  Let’s suppose…  Having the party is worth $150 to you…  …and a good night’s sleep is worth $100 to me  So it’s efficient to have the party  If parties are allowed…  No need for negotiation  If parties are not allowed…  My threat point: 0  Your threat point: 0  Gains from cooperation: $50  If split evenly: payoffs are $25 and $25  Which requires you paying me $125 to have the party One more example – you having a party next door to my house

18. 17 When are stronger property rights “worth it”?

19. 18 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 FarmSteal Farm Steal Player 2 Player 1 10, 10-5, 12 12, -50, 0 FarmSteal Farm Steal Player 2 Player 1 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

20. 19  Incentive to overuse communal resources  “Tragedy of the commons” – private property rights can fix this  Collective farming – incentive to shirk/freeride  Again, private property rights fix this – for example…  “It’s one of the ironies of American history that when the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death.  Fortunately… Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced. Bradford described the results…  “[Ending corn collectivism] had very good success, for it made all hands very industrious… The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability…”” - Marginal Revolution (blog post), “Thanksgiving Lessons” Private property leads to better use of resources, by eliminating externalities

21. 20  “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, “Toward a Theory of Property Rights”

22. 21  “A close relationship existed, both historically and geographically, between the development of private rights in land and the development of the commercial fur trade.  Because of the lack of control over hunting by others, it is in no person’s interest to invest in increasing or maintaining the stock of game. Overly intensive hunting takes place.  Before the fur trade became established, hunting was carried on primarily for purposes of food and the relatively few furs that were required for the hunter’s family. The externality was clearly present… but these external effects were of such small significance that it did not pay for anyone to take them into account.” Harold Demsetz, “Toward a Theory of Property Rights”

23. 22  “The advent of the fur trade had two immediate consequences. First, the value of furs to the Indians was increased considerably. Second, and as a result, the scale of hunting activity rose sharply. Both consequences must have increased considerably the importance of the externalities associated with free hunting. The property right system began to change…”  …even though property rights were not developing in the Southwest, where the commercial fur trade had not developed Harold Demsetz, “Toward a Theory of Property Rights”

24. 23  “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”  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 Harold Demsetz, “Toward a Theory of Property Rights”

25. 24  “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”  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 Harold Demsetz, “Toward a Theory of Property Rights”

26. 25 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”

27. 26 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. Friedman tells a similar story: “we owe civilization to the dogs”

28. 27 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 Friedman tells a similar story: “we owe civilization to the dogs”

29. 28  Coase: if property rights are complete and tradable, we’ll always get efficiency  can “fix” externalities by expanding property rights to cover  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 So…

30. 29 “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.” Of course, Coase wasn’t actually ignoring costs…

31. 30  What are transaction costs, and how do we deal with them? So…

32. 31 Transaction Costs

33. 32  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?

34. 33  Asymmetric information  Akerloff (1970), “The Market for Lemons” – adverse selection Bargaining costs come in many forms

35. 34  Asymmetric information  Akerloff (1970), “The Market for Lemons” – adverse selection Bargaining costs come in many forms Quality of car Proba- bility Value to Me Value to You Great Decent Terrible 1/3 $6,000 $3,000 $0 $4,000 $2,000 $0 Average value to me: $3,000 Average value to me: $1,500

36. 35  Asymmetric information  Akerloff (1970), “The Market for Lemons” – adverse selection  Private information (don’t know each others’ threat points)  Myerson and Satterthwaite (1983), “Efficient Mechanisms for Bilateral Trading” – always some chance of inefficiency Bargaining costs come in many forms

37. 36  Asymmetric information  Akerloff (1970), “The Market for Lemons” – adverse selection  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 Bargaining costs come in many forms

38. 37  Large numbers of parties  Developer values large area of land at $1,000,000  10 homeowners, each value their plot at $80,000 Bargaining costs come in many forms

39. 38  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 Bargaining costs come in many forms

40. 39  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

41. 40 So, what do we do?

42. 41  No transaction costs / bargaining is easy  initial allocation of rights doesn’t matter for efficiency  wherever they start, people will trade until efficiency is achieved  Significant transaction costs / bargaining is hard  initial allocation does matter, since trade may not occur (and is costly if it does)  This leads to two normative approaches we could take  Minimize the cost of bargaining  Minimize the need for bargaining What we know so far…

43. 42  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

44. 43  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

45. 44  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?

46. 45  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

47. 46  For next week: Calabresi and Melamed That’s it for today