1 Agenda for 14th Class Coase Theorem (continued) Sarnoff Assignment for Next Class Ex. 14. Cleaner Skies Writing Assignments –Cleaner Skies (Groups 1 and 4) 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 how legal rights were initially assigned –Alternative. If there are no transactions, resources will flow to their highest valued use, regardless of legal rule –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, the initial allocation of legal rights will be irrelevant, because resources will be allocated efficiently and the same, regardless of how legal rights were initially assigned 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 Last Class: Ancient Lights Two possible legal rules –Prior owner has right to enjoin construction which would block light (“ancient lights”) –Prior owner of building has no such right (American rule) Builder makes $20,000 profit from new building Ancient LightsAmerican Rule Prior Owner values light $10,000 New building built. Builder pays prior owner between 10K and 20K New building built. No negotiation needed (or successful) Prior Owner Values light $40,000 New building not built. No negotiation needed (or successful) New building not built. Prior owner pays builder between 20K and 40K New building built if profits of new building are greater than prior owner’s valuation of light (regardless of legal rule) New building not built, if owner’s valuation of light is greater than profits of new building (regardless of legal rule)

4 Wealth Effects Previous slide assumed that willingness to pay = willingness to accept (WTP = WTA) –No “wealth effects” –No “endowment effects” –Illustrated strong version of Coase Theorem Efficient allocation and same allocation If Builder values building $20K and owner values light $10K, new building built and net surplus of 10K under both Ancient Lights and American Rule If Builder values building $20K and owner values light $40K, then new building not built under both rules. That’s efficient because building the new building would result in a reduction of $20K in net benefits Suppose WTP < WTA –See next slide

5 Ancient Lights with Wealth Effects Builder makes $20,000 profit from new building Owner WTP = $15,000 Owner WTA = $25,000 Ancient lights -- Building not built –Most builder will offer for permission to build is $20,000, but owner will not accept anything less than $25,000 (her WTA) –Not building is efficient, because building reduces net benefit by $5,000 Benefit to builder is $20,000 Loss to owner is $25,000 (as measured by WTA) American rule -- Building will be built –Most owner will offer to stop building is $15,000 (her WTP), but builder will build unless given at least $20,000 –Building is efficient, because not building would reduce benefit by $5K $20,000 loss to builder Gain of only $15,000 to owner (as measured by WTP) Illustrates weak version of Coase Theorem –Allocation always efficient, but depends on legal rules (initially assignment of rights) Hard to know what is normatively correct when WTP < WTA by big margin

6 Coase Theorem and Assigning Rights I (A-C1 only) Coase Theorem helps figure out how rights should be allocated in the first place How depends on context Ancient Lights –If profit to new building usually higher than prior owner’s valuation of light Then, if transactions costs are zero new building will be built, regardless of legal rule BUT if transactions costs are positive and moderate, ancient lights rule will require costly negotiation –If transactions costs are very high, then ancient lights rule will block efficient allocation So American rule more efficient –Converse if prior owner’s valuation of light is higher than profit to new building

7 Coase Theorem and Assigning Rights II (A-C1 only) Pollution –If transactions costs are zero, pollution controlled optimally, no matter the legal rule –Transactions costs are, in fact, very high, b/c too many people affected So rule which allocated right to pollute to potential polluters would result in an efficiently high amount of pollution –Removing right to pollute (e.g. through pollution taxes or regulation) is efficient Of course, most efficient form of pollution control subject to debate

8 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.

9 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?

10 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

11 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.

12 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.”

13 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?

14 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

15 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

16 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