Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 5

1  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…

2 When are stronger property rights “worth it”?

33 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

4  “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”

5  “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 (1967), “Toward a Theory of Property Rights”

6  “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 (1967), “Toward a Theory of Property Rights”

7 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”

8 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”

9 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”

10  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…

11 Transaction Costs

12  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?

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

14  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

15  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

16  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

17  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

18 Example of high transaction costs with many sellers

19  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

20 So, what do we do?

21  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…

22  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

23  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

24  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?

25  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

26 Designing an efficient property law system

27 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

28 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

29  When private goods are owned publicly, they tend to be overutilized/overexploited Public versus Private Goods

30  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied Public versus Private Goods

31  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

32  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

33  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

34 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

35  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

36 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)

37 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

38  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

39  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

40  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

41 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

42 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)

43  Injunctions are generally cheaper to administer  No need for court to calculate amount of harm done Comparing injunctions to damages…

44  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…

45  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…

46 “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

47 “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…

48  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

49  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium) Third way to protect an entitlement: inalienability

50  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium)  “Indirect” externalities (human organs) Third way to protect an entitlement: inalienability

51  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium)  “Indirect” externalities (human organs)  Paternalism Third way to protect an entitlement: inalienability source: National/2011/06/02/Boy%2Bregrets%2Bselling %2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/

52 (we’ll probably end here)

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

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

55  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?

56  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?