Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 5

1  HW1 due online at 11:59 p.m. Thursday Reminder

2  Coase Theorem: In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency.  The initial allocation of property rights therefore does not matter for achieving efficiency…  …provided there are no transaction costs  On the other hand, the initial allocation does affect distribution…  And if there are transaction costs, it can also affect efficiency Monday, we saw the Coase Theorem

3 Foxes

44  Pierson v. Post (NY Supreme Court, 1805)  Lodowick Post organized a fox hunt, was chasing a fox  Jesse Pierson appeared “out of nowhere,” killed the fox and took it  Post sued to get the fox back  Lower court sided with Post; Pierson appealed to NY Supreme Court  Question: when do you own an animal? One early, “classic” property law case

55  Court ruled for Pierson (the one who killed the fox)  “If the first seeing, starting, or pursuing such animals… should afford the basis of actions against others for intercepting and killing them, it would prove a fertile source of quarrels and litigation”  (Also: just because an action is “uncourteous or unkind” does not make it illegal)  Dissenting opinion: a fox is a “wild and noxious beast,” and killing foxes is “meritorious and of public benefit”  Post should own the fox, in order to encourage fox hunting One early, “classic” property law case

66 Pierson gets the fox  simpler rule (finders keepers)  easier to implement  fewer disputes Same tradeoff we saw earlier: Post gets the fox  more efficient incentives  (stronger incentive to pursue animals that may be hard to catch)  Just like Fast Fish/Loose Fish vs Iron Holds The Whale  Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes  Iron Holds the Whale is more complicated, but is necessary with whales where hunting them the old-fashioned way is too dangerous

7  Coase seems to say: for efficiency, it doesn’t matter who starts off with the right to the fox  If Post values it more, he can buy it from Pierson, or vice versa  Seems to imply: one rule is just as good as the other, as long as we all know what the rule is  So why does Pierson v Post matter?  Transaction costs!  Majority: if Post gets the fox back, “it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly  Dissent: killing foxes is a good thing (externality), so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining Doesn’t Coase make Pierson v Post irrelevant?

8  Coase: “in the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.”  This suggests that if there are transaction costs, voluntary negotiations may not lead to efficiency  Car example (yet again)  If transactions are costly, we may not trade  And if we do trade, we incur that cost Transaction costs

9 “If market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast. But… the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law. In such cases, the courts directly influence economic activity. …Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out. Quoting Coase…

10  “In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.”  We can read this as…  “As long as transaction costs aren’t a big deal, we’ll get efficiency”  Or as, “we’ll only get efficiency automatically if there are no transaction costs”  Coase also gives two examples of institutions that may emerge in response to high transaction costs:  Firms  Government regulation We can see the Coase Theorem as either a positive or negative result

11  Overfishing in communal lake?  It’s because property rights over those fish aren’t well-defined  Firm polluting too much?  It’s because property rights over clean air aren’t well-defined  So one solution…  Make property rights complete enough to cover “everything,” and tradable, and use the law to minimize transaction costs…  …Then Coase kicks in and we get efficiency! (Booya!)  So why not do this? COSTS! Many externalities can be thought of as missing property rights

12  General equilibrium  given prices, consumers maximize utility  given prices, firms maximize profits  prices are such that all markets clear  First Welfare Theorem: general equilibrium is efficient  But not when there are externalities, or “missing markets”  Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights Relating Coase to general equilibrium/ first welfare theorem

13  General equilibrium  given prices, consumers maximize utility  given prices, firms maximize profits  prices are such that all markets clear  First Welfare Theorem: general equilibrium is efficient  But not when there are externalities, or “missing markets”  Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights Relating Coase to general equilibrium/ first welfare theorem

14 Bargaining

15 Let’s go back to our rancher and farmer Do nothing: $500 in crop damage

16 Let’s go back to our rancher and farmer Rancher builds fence: $400 Farmer builds fence: $300

17  Three possibilities  Nobody builds a fence – $500 in damage  Rancher builds fence – $400 cost  Farmer builds fence – $300 cost  Suppose we’re in a farmer’s rights world  Rancher is liable for any damage done by his herd  What does Coase predict will happen?  They’ll bargain to efficient outcome  Meaning, the farmer will build a fence (and the rancher will pay him)  How much will he pay? Let’s go back to our rancher and farmer No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

18  Threat point – each party’s expected outcome if bargaining fails  “If we can’t agree to a deal and we go our separate ways, how well off am I?”  Also called outside option, or reservation utility  Deal has to make everyone better off than that! Before bargaining: threat points No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

19 Threat points No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point. What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point.

20 Threat points No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point

21  So under a closed-range law…  The farmer’s threat point is 0, the rancher’s is –$400  Those are the payoffs that will happen if no agreement is reached  If a deal happens: total payoffs go up from –$400 to –$300  Farmer will build a fence (efficient outcome), rancher will pay him some money  Cooperation causes total payoffs to go up by $100  So $100 is gains from cooperation (or gains from trade) Gains from cooperation No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

22  Coase predicts negotiation will lead to efficiency  So the gains from cooperation will be realized  (The farmer will build a fence)  Both sides have to do at least as well as their threat point  Otherwise, wouldn’t agree to deal  So rancher will pay farmer somewhere between $300 and $400 to build the fence  But what if we want a more precise prediction? So what will happen? No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

23  What if gains from cooperation were split evenly?  Threat points 0 and –400, gains of 100  Farmer’s payoff: 0 + ½ (100) = 50  Rancher’s payoff: –400 + ½ (100) = –350  How is this achieved? Rancher pays farmer $350 to build fence So what will happen? No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

24 If gains are split evenly… -300Combined Payoffs Farmer’s Payoff Rancher’s Payoff (IF…) 100Gains From Cooperation 0Farmer’s Threat Point -400Rancher’s Threat Point Farmer’s Rights No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 –400 + ½ (100) 0 + ½ (100) = –350 = 50

25 If gains are split evenly… -300 Combined Payoffs Farmer’s Payoff -3500Rancher’s Payoff (IF…) 1000Gains From Cooperation 0-300Farmer’s Threat Point -4000Rancher’s Threat Point Farmer’s RightsRancher’s Rights =  No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300

26  Let’s suppose…  Having the party is worth $150 to you…  …and a good night’s sleep is worth $100 to me  So it’s efficient to have the party  If parties are allowed…  No need for negotiation  If parties are not allowed…  My threat point: 0  Your threat point: 0  Gains from cooperation: $50  If split evenly: payoffs are $25 and $25  Which requires you paying me $125 to have the party One more example – you having a party next door to my house

27 When are stronger property rights “worth it”?

28 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

29  Incentive to overuse communal resources  “Tragedy of the commons” – private property rights can fix this  Collective farming – incentive to shirk/freeride  Again, private property rights fix this – for example…  “It’s one of the ironies of American history that when the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death.  Fortunately… Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced. Bradford described the results…  “[Ending corn collectivism] had very good success, for it made all hands very industrious… The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability…”” - Marginal Revolution (blog post), “Thanksgiving Lessons” Private property leads to better use of resources, by eliminating externalities

30  “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”

31  “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”

32  “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”

33 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”

34 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”

35 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”

36  Coase: if property rights are complete and tradable, we’ll always get efficiency  can “fix” externalities by expanding property rights to cover  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 So…

37 “If market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast. But… the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law. In such cases, the courts directly influence economic activity. …Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out.” Of course, Coase wasn’t actually ignoring costs…

38  What are transaction costs, and how do we deal with them? So…

39 Transaction Costs

40  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?

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

42  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

43  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

44  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

45  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

46 Example of high transaction costs when there are many sellers

47  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

48 So, what do we do? (won’t get to this)

49  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…

50  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

51  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

52  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?

53  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

54  HW due tomorrow night at midnight  For next Monday: read Calabresi and Melamed That’s it for today