An Economic Theory of Property Chapter 4 An Economic Theory of Property

Any system of property law must answer the following questions: 1) How are property rights initially assigned? (or how does a person acquire ownership of something?) 2) What can be privately owned? (or what should be publicly owned?) 3) What may owners legitimately do with their property? (Incompatible use) 4) What are the remedies for the violation of property rights?

Overview Economics is the study of resource use. The law of property supplies the legal framework for allocating resources and distributing wealth. An economic theory tries to predict the effects of alternative forms of ownership, especially the effects on efficiency and distribution. So, in this chapter we want to explore how alternative property rules create incentives to use resources efficiently.

The legal concept of property Property is a bundle of rights and the rights describe what people may and may not do with the resources they own. Two notes about property rights: 1) The owner is free to exercise, or not exercise, the rights over the property. 2) Others are forbidden to interfere with the owner’s exercise of his rights. Owners can exercise their will over things without being answerable to others.

Bargaining theory Let’s consider an example and then use the example to define some terms. Adam owns a car and the pleasure of owning and driving the car is worth $3000 to him. Blair has $5000 to spend, she knows about the car and decides the pleasure of owning and driving the car is worth $4000 to her. If she doesn’t buy the car she will buy stuff worth $5000 to her. Now, the owner of the car values the car less than the potential buyer. There is room for bargaining to occur.

Bargaining theory Let’s say if they negotiate and trade that cooperation has occurred. A noncooperative solution would be reached if they do not trade. Let’s write down the noncooperative values in society in this example: Adam 3000 Blair 5000 Total 8000 Value here would be called threat values. Adam, the seller, would “threaten” to not trade if he didn’t get more than 3000 and Blair, the buyer, would “threaten” to not trade if she does not end up with value of more than 5000.

Bargaining Theory Let’s write down the cooperative value in society in this example, assuming the trade is for $3500: Adam 3000 + 500 Blair 4000 + (5000-3500) Total 9000 The cooperative surplus from trade is 9000 - 8000 = 1000. Voluntary trade is beneficial to society and the benefits are distributed by negotiation on price. In this example each obtains half of the surplus.

Cooperative surplus How can we interpret the cooperative surplus? The seller originally has the good and is implicitly saying the good will be kept unless when the good is given up he can buy other goods he would value at least as much or more. The buyer originally does not have the good in question, but has the ability to get other goods and is implicitly saying the good in question will only be obtained if it gives at least as much value as the goods that must be given up.

Coase Theorem Let’s consider another example that originates with the ideas of a man named Ronald Coase. A corn farmer and a cattle rancher live next to each other and there is NO FENCE between them. The cattle sometimes eat $100 worth of corn. The farmer could fence in his land for $50. The rancher could fence in her land for $75. Now the law might say one of two (maybe more, we focus on two) things: 1) Open range - the farmer is responsible for his own damage, 2) Closed range - the rancher is responsible for the damage his cattle cause.

Coase Theorem Let’s think about the open range case. The farmer could lose the $100 or put up a fence. The fence would lead to a net saving of $50 for the farmer. Well, the farmer would say I gain by putting up the fence and the fence would then be around the farmer’s land. Now let’s consider the closed range case. The rancher could lose $100 or put up a fence. The fence would lead to a net saving of $25 for the rancher. Well, the rancher would say I gain by putting up the fence and the fence would then be around the rancher’s land.

efficiency It seems the problem here is the loss of the corn valued at $100. If we save the corn, society is $100 better off. But we have to consider the cost and when doing so the farmer can save the corn in a more cost saving manner. Society would be better off under an open range rule here. Here is where Coase comes into play. He said wait a minute. Maybe society could have the same situation under a closed range rule.

Coase Theorem Under a closed range rule the rancher might say, “hey farmer, why don’t I pay you $50 to put a fence around your property?” The farmer would gain his $100 and the rancher would only have to pay $50. Society would then have the same outcome under the closed range as under the open range. The fence would be around the farm and value of $50 would be generated in society. WAIT, you say. The farmer may feel uneasy and here is what the farmer is thinking: If I don’t let you pay me to build a fence I get $100 and you build your own for $75 and if I let you pay for my fence I get $100 and you pay for my fence and are out $50. Why should I let you gain $25, or shouldn’t I get some of the $25? The is room for BARGAINING.

Coase Theorem Say they cooperate and they agree the rancher will pay the farmer $62.5 to have the fence built around the farm. Now the farmer gains 162.5 - 50 = 112.5 and the rancher pays 62.5 for the fence. Society has a gain of $50. Conclusion: If bargaining can occur, no matter what the legal rule, the fence will be built around the farm and there will be a net saving in society of $50.

Surplus Notice in the example that I said there is a gain of $50 from the activity of putting up the fence. When you think back to the car example we talked about a cooperative surplus. In the current example the surplus is only $25. The farmer values the fence at $50 and the rancher values the fence on the farmers land by as much as $75. The cooperation will create $25 worth of surplus value.

Summary of Coase Theorem Here is the Coase theorem: When transaction costs are zero, an efficient use of resources results from bargaining, regardless of the legal assignment of property rights. In other words, property laws are unimportant to efficient land use when transaction costs are zero. Corollary to Coase theorem: When transaction costs are high enough to prevent bargaining, the efficient use of resources will depend upon how property rights are assigned. Let’s think about what transaction costs are next.

Transaction costs Transaction costs are the costs of exchange. Exchange has three components and thus we have three cost components. We have 1) Search cost - finding someone with whom to trade money for product. 2) Bargaining cost - negotiating the terms of trade. 3) Enforcement cost - monitoring performance of parties and punishing violations of the agreement. Table 4.3 lists factors that would influence the level of transaction costs. Let’s look at the list on page 94.

Back to example Farmer fence $50 Rancher fence $75 Rancher would like to pay Farmer $50 and create a surplus of $25 that the two may somehow share. What if the transaction costs are $10? Would the fence still get built on the farmers land? Yes, but the surplus is only $15 - still enough to trade. What if the transaction costs are $35? Would the fence still get built on the farmers land? No, the surplus is -$10 - not enough to trade. There is a threshold transaction cost that will mean the rancher will put a fence around his land - not the best outcome.

Normative Coase Theorem Normative suggests opinion. Opinion can be shaped by how we view the world. If efficiency is our motivating force and the Coase theorem is a summary of efficiency in the economy, then the theorem may be used to form my opinion. Normative Coase theorem: Structure the law so as to remove the impediments to private agreements. Example: requiring public recording of property claims makes determining ownership easier.

Thomas Hobbes A while back a guy named Hobbes said people would not be able to agree on the distribution of the surplus and thus not do the right thing. He felt at these times a third party would have to impose on the parties the “right thing.” This leads to the NORMATIVE Hobbes Theorem: Structure the law so as to minimize the harm caused by failures in private agreements. In other words, grant rights to parties who value them most.

surplus 45 degree line – indifference to trade Trade zone No trade zone Transaction costs

Figure slide 20 The vertical axis labels the surplus that could be achieved when legal rights are traded. The horizontal axis is the level of transaction costs. The 45 degree line provides a reference point for comparing transaction costs and surplus. If transaction costs = surplus for a given situation we would be on 45 degree line and individuals would be indifferent to trade. If the transaction cost > surplus for a situation, then we would be below the 45 degree line and trade would not happen. Hopefully the law would reduce the impediment to trade.

Figure If the transaction cost < surplus for a situation, then we would be above the 45 degree line and trade would happen.

Remedies What are the remedies for the violation of property rights? 1) Compensatory money damages - make the plaintiff whole. 2) Injunctive relief - enjoin defendant to do or refrain from doing some specific act. From farmer/rancher example - court may enjoin the rancher from having his cattle on the farmer’s property. The injunction would be a clear assignment of a property right. But the right could then be sold. Bargaining in the shadow of the law - not at trial, but bargaining is affected by the remedy that would (likely) prevail at trial.

Another example In this example, for now, assume that transaction costs are zero. An electric company, call it E, pollutes the air and this causes damage at the laundry mat, called L. E will have a profit of $1000, unless it installs pollution scrubbers for $500 and thus profit will be $500. The scrubbers eliminate the pollution. L will have a profit of $300 if E installs scrubbers. Now if E does not install scrubbers, L can install a filter for $100 that will eliminate the impact of the pollution, but reduce the profit to $200. If L does not get the filter (and no scrubber by E) it will suffer a loss of $200 and thus have profit of only $100.

Legal Rules Let’s examine some different legal rules the court might apply to the example and see what happens between the parties. 1) Polluter’s rights - E can pollute. E will not buy the scrubbers and have a profit of 1000 and L will buy the filter because it would rather have 200 profit instead of 100. Summary: E - 1000, L - 200. L would like to change this but has no room to bargain. Cooperation will not be able to occur here. A filter is installed by L.

Legal Rules 2) Pollutee’s rights to damages - E pays for its pollution and L has no duty to mitigate, meaning install a filter. E still will not buy the scrubbers - profit = 1000 - 200 = 800 L will NOT get a filter - profit = 100 + 200 = 300 Now with zero transaction costs, bargaining can occur. It will be recognized that if E pays less than 200 it will be happier. L would like more than a 300 total. Here is how it can get it. L can buy its own filter and have profit of 200 and if E pays more than 100 E is better off. Say E pays L 150. Summary: E - 1000 - 150 = 850, L - 200 + 150 = 350. Cooperation occurs here. A filter is installed.

Legal Rules 3) Pollutee’s rights to injunction - E can not pollute and L has the right to be free of pollution. E will buy scrubbers - profit = 1000 - 500 = 500. L does not need filter - profit = 300. Now with zero transaction costs, bargaining can occur. It will be recognized that if E pays less than 500 it will be happier. L would like more than a 300 total. Here is how it can get it. E can buy the filter for L and then E will give L some of the other 400 it saves by not buying a scrubber. Say E gives L 200. Summary: E - 1000 - 100 - 200 = 700, L - 300 + 200 = 500. Cooperation occurs here. A filter is installed.

Some conclusions If the parties CAN NOT cooperate, only one legal rule is efficient - polluter’s rights. If the parties CAN cooperate (under zero transaction costs), efficiency results no matter what legal rule is established. Now, if transaction costs are zero, what difference does the law make? It does matter. It matters in the distribution of the cooperative surplus. E prefers polluter’s rights and L prefers injunction.

Efficient Remedies From the previous example let’s look again at the damage ruling and the injunction ruling. This time let’s have transaction costs being greater than zero. Let’s start by saying that transaction costs are really high. This would make cooperation untenable. So under damages we had E - 800 and L - 300 and under injunction we had E - 500 and L - 300. Damages are more efficient. L is indifferent between the two, but E prefers the damages.

Efficient Remedies Let’s now say transaction costs are relatively low. Cooperation might be able to occur. In fact, it seems reasonable to think that transaction costs under injunction would be lower than under damages because an injunction is a relatively easy rule to follow. So under damages we had E - 800 and L - 300 and there is room to gain 100 more. Under injunction we had E - 500 and L - 300 and room to gain 400 more. The injunction would tend to be more efficient because the larger gain means it can overcome higher transaction costs.