1 Agenda for 14th Class Sarnoff Assignment for Next Class & Writing Assignment for Group 2 –Ex. 14. Cleaner Skies –2011 exam –Good for everyone to write out

2 Last Class: Coase Theorem Weak version: If there are no transactions costs, resources will be allocated efficiently regardless of the legal rule –Alternative. If there are no transactions, resources will flow to their highest valued use, regardless of the assignment of legal rights –Alternative. If there are no transactions costs, social welfare (consumer + producer surplus) will be maximized, regardless of legal rule Strong version. If there are no transactions costs, resources will be allocated efficiently and the same, regardless of how the legal rule. Intuition –If there are no transactions costs, then efficiency will be achieved through voluntary transactions –If transaction increases social surplus, then it can be structured in a way that makes everyone better off So if no transactions costs, no reason for transaction not to occur

3 Externalities & Coase Theorem When externalities affect small number of people who can negotiate ex ante or who deal with each other repeatedly, probably don’t need law to correct or encourage –Nice or mean things done to family or friends –Contracts usually deal explicitly with externalities E.g. promisee pays for positive externality granted by promisor Parties indemnify each other for harm But law sometimes imposes mandatory terms –E.g. Product liability, medical malpractice liability –Covenants running with land, homeowners associations Deal with externalities among neighbors But when externalities affect large numbers of people, need law –Pollution, congestion, torts among strangers, etc.

4 Question on Coase Theorem A simple application of the Coase Theorem might suggest that product liability was unnecessary.… If consumers value the right to sue manufacturers for defective products, but tort law does not require manufacturers to provide it…manufacturers would voluntarily provide consumers with warranties that provide compensation to consumers in the event they are harmed by defective products. Of course, manufacturers would charge more for products with such warranties than without, but if consumers value such warranties, they would be willing to pay for them and manufacturers would provide them. Does this argument convince you that product liability is unnecessary? Suppose you were a plaintiff’s lawyer representing a person harmed by a defective product and opposing counsel argued that the case should be dismissed because common-law products liability should be abolished. In support of dismissal, opposing counsel made the above Coase Theorem argument. How would you respond?

5 Sarnoff I Sarnoff’s employment contract contained non-competition condition –Incentive pay award (stock) paid only if not competing –Contract governed by NY Law Sarnoff quit and formed Ensar, a company which AHP says is competing Sarnoff argued –A) NY law forbids enforcement of non-competition conditions –B) Ensar not competing with AHP District court –NY law forbids enforcement of non-competition conditions Erie doctrine. State law governs common law issues in federal court –Did not decide issue of whether Ensar competing with AHP Court of Appeals (Posner, J) –NY law does not forbid enforcement of non-competition conditions –Remand to District Court to determine whether Ensar is competing with AHP

6 Sarnoff II 1a. Suppose that Sarnoff anticipates that his new business, Ensar Corp., will generate $1,000,000 in profit, while American Home Products anticipates that Ensar will reduce American Home Products’ profit by $500,000. What is the “position that maximizes their joint wealth”? Would their joint wealth be maximized by Sarnoff starting or not starting his new business? Does your answer depend on whether the non-competition condition is enforced? For the purposes of this and the following questions, assume that, on remand, the lower court holds that the incentive award committee acted reasonably in finding that Sarnoff’s company would compete with American Home Products. b. Suppose that the non-competition condition were valid and the stock that Sarnoff would get if he complied with the condition were worth $800,000. Would Sarnoff start his new business? c. Same question as (b), but the stock was worth $1,200,000? In answering this question, consider carefully the possibility that Sarnoff and American Home Products might negotiate after Sarnoff left American Home Products but before Sarnoff started his new business.

7 Sarnoff III d. Suppose the contract between Sarnoff and American Home products had included a covenant not to compete rather than a non- competition condition. The covenant not to compete forbade Sarnoff from starting or working for a competing business. A covenant not to compete, if valid, can be enforced by an injunction, so Sarnoff could be imprisoned if he persisted in violating it. Would Sarnoff start his new business? In answering this question, consider carefully the possibility that Sarnoff and American Home Products might negotiate. Is your answer affected by how much money Sarnoff has in his bank account at the time he starts his new business? By his ability to borrow money? Is Posner correct in his application of the Coase Theorem? That is, is he right that “under either arrangement, which is to say whatever the initial assignment of rights – whether the employer has the right to prevent the employee from competing or the employee the right to compete but at some previously determined price – the parties, because there are only two of them (so that the costs of transacting should not be prohibitive), will be able to bargain their way to the position that maximizes their joint wealth.”

8 Sarnoff IV 2. If Judge Posner is correct, that the parties will “bargain their way to a position that maximizes their joint wealth,” whatever the applicable legal rule, why was it worthwhile for Sarnoff to incur the cost of litigating this lawsuit? 3. If Judge Posner is correct, that the parties will “bargain their way to a position that maximizes their joint wealth,” whatever the applicable legal rule, why was it worthwhile for American Home Products to incur the cost of drafting the contract that included the non-competition condition? 4. Posner’s opinion considers only the maximization of Sarnoff’s and American Home Products’ wealth. Are there any other persons whose wealth (or well-being) are affected? Should their interests be considered? 5. What does Posner mean when he writes, “presumably the employee would have been compensated in advance for agreeing to a covenant that would restrict his freedom of future action”? 6. Is Posner’s discussion of the Coase Theorem dicta?

9 Prisoners’ Dilemma Suspect 2 ConfessKeep quiet Suspect 1Confess-5, -5-1, -7 Keep Quiet-7, Dominant Strategy. Nash Equilibrium Each suspect imposes negative externalities on the other Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

10 Pollution Externalities Game Firm 2 PolluteInstall Firm 1Pollute-4000, , Install-5000, Almost identical to Prisoners’ dilemma If numbers small, might expect agreement to install pollution control When numbers large, negotiation very difficult –Collective action problem Everyone better off if everyone installs pollution control equipment But each person better off if free rides –Better to not install pollution control equipment, if everyone else does

11 Collective Action Problems Collective Action Problems are ubiquitous –Becoming informed voter, voting –Funding public goods, e.g. fire departments, bridges, national defense –Global warming –Fishing Every collective action problem is also an externalities problem –Sometimes groups can resolve Political lobbying by interest groups Democracy Voluntary organizations Clubs –Often government is only or best solution