Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 5

1  Coase Theorem: in the absence of transaction costs, if property rights are well-defined and tradeable, we’ll always get efficiency  Or: if property rights are complete enough, we can overcome externalities  Demsetz: but more complete property rights are more costly to implement  property rights will expand when the benefits outweigh the costs  either because the benefits rise (Demsetz)…  …or because the costs fall (Friedman)  Next: what are transaction costs? Monday…

2 Transaction Costs

3  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?

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

5  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

6  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

7  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

8  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

9  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

10 So, what do we do?

11  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…

12  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

13  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

14  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?

15 Designing an efficient property law system

16 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

17  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

18  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 Three possible ways to protect an entitlement

19  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  Liability rule / damages  Damages are a payment to a victim to compensate for actual damage done  Better when prior negotiation is impossible  Inalienability Three possible ways to protect an entitlement

20  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

21  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 to damages – example E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100

22  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 the non-cooperative outcomes E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100

23 Noncooperative payoffs 8001,1001,200 Combined payoff (non-coop) L payoff (non-coop) ,000 E payoff (non-coop) InjunctionDamagesPolluter’s Rights E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100

24 What about with bargaining? 1,200 Combined L payoff (coop) ,000E payoff (coop) Gains from Coop 8001,1001,200 Combined payoff (non-coop) L payoff (non-coop) ,000 E payoff (non-coop) InjunctionDamagesPolluter’s Rights E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = ½ (100) ½ (100) ½ (400) ½ (400)

25  In this case…  Polluter’s rights > damages > injunction when there is no bargaining  All three equally efficient when there is bargaining  Normative Hobbes: allocate rights efficiently to begin with  Polluter’s rights in this case, no reason to believe this more generally  Normative Coase: just work to lower transaction costs, let people negotiate when they need to  So what do we do? How do we choose between the rules?

26  Injunctions are cheaper for court to implement  No need to calculate exact amount of damage done  Damages are more efficient when private bargaining fails  Leads Calabresi and Melamed to the following conclusion: When transaction costs are high, a liability rule (damages) is more efficient When transaction costs are low, a property rule (injunctive relief) is more efficient How do we choose between the rules?

27  Calabresi and Melamed When transaction costs are high, a liability rule (damages) is more efficient When transaction costs are low, a property rule (injunctive relief) is more efficient  Why are damages more efficient when bargaining fails?  Under damages rule, injurer has two choices: prevent the damage, or pay cost afterwards  Under injunction, injurer has only one choice: prevent the damage  Injuree is compensated, so doesn’t matter to him  So whichever is cheaper for injurer, is more efficient So that’s our answer:

28 “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  damages Low transaction costs  injunctive relief

29 “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…

30  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

31  Inalienability: when an entitlement is not transferable or saleable Third remedy: inalienability

32 what can be privately owned? what can an owner do? how are property rights established? what remedies are given?