Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 3

1  efficiency: “when there is no way to make some people in the economy better off, without making others worse off by more”  saw some examples of forces that lead to inefficiency  externalities; barriers to trade; monopoly/private information; taxes  considered limitations of efficiency  doesn’t address equity/distribution; assumes value = willingness to pay (everything is monetizable); only considers outcomes, not process  saw two arguments why the law should be designed to be efficient  Posner: ex-ante consent  Cooter/Ulen: if we’re worried about distribution/equity, better to design the law to be efficient, use tax system to redistribute wealth Tuesday, we discussed efficiency

2  introduce some basic game theory  begin property law Today:

3  I don’t have many “absolute beliefs” about economics  Some people do  I hope that doesn’t make things too confusing  Relatedly, if I don’t see economics as a set of rules to memorize, how do I know what I know?  I need to see a model, or an example, that demonstrates it But first, a quick digression…

4 Some basic game theory

5  Today, we focus on static games  Also known as simultaneous-move games  A static game is completely described by three things:  Who the players are  What actions are available to each player  What payoff each player will get, as a function of  his own action, and  the actions of the other players  Any complete description of these three things fully characterizes a static game A brief introduction to game theory

6  (Story)  Players: player 1 and player 2  Two actions available to each player: rat on the other, or keep mum  Payoffs:  u 1 (mum, mum) = -1  u 1 (rat, mum) = 0  u 1 (mum, rat) = -10  u 1 (rat,rat) = -5  Same for player 2 A classic example: the Prisoner’s Dilemma

7 In two-player games with finite actions, one way to present game is payoff matrix -1, -1-10, 0 0, -10-5, -5 MumRat Mum Rat Player 2’s Action Player 1’s Action Player 1’s PayoffPlayer 2’s Payoff Always Player 1

8  In the Prisoner’s Dilemma, one player’s best action is the same, regardless of what his opponent does  This is called a dominant strategy  Regardless of what he thinks 2 will do, 1 will choose to play Rat Dominant Strategies -1, -1-10, 0 0, -10-5, -5 MumRat Mum Rat Player 2’s Action Player 1’s Action

9  In most games, players won’t have a single move that’s always best  We solve a game by looking for a Nash equilibrium  Nash equilibrium is a strategy profile (an action for each player) such that:  No player can improve his payoff by switching to a different action…  Given what his opponent/opponents are doing Nash Equilibrium

10  Is (Mum, Mum) an equilibrium?  No, if player 2 is playing Mum player 1 gains by deviating  If any player can improve his payoff by changing his action, given his opponents’ actions, then it is not a Nash equilibrium A strategy profile is a Nash Equilibrium if no player can gain by deviating -1, -1-10, 0 0, -10-5, -5 MumRat Mum Rat Player 2’s Action Player 1’s Action

11  Given a possible action by my opponent, my best response is whatever action(s) give me the highest payoff  To find Nash Equilibria…  Circle payoff from player 1’s best response to each action by his opponent  Circle payoff from player 2’s best response to each action  Any box with both payoffs circled is an equilibrium  In the Prisoner’s Dilemma game, (Rat, Rat), or “Both players play Rat”, is the only Nash equilibrium In two-player games, we find Nash equilibria by highlighting best responses -1, -1-10, 0 0, -10-5, -5 MumRat Mum Rat Player 2’s Action Player 1’s Action

12  Another classic: Battle of the Sexes  (Story)  Circle player 1’s best responses  Circle player 2’s best responses  We find two equilibria: (ballgame, ballgame) and (opera, opera)  Game theory usually doesn’t have that much to say about which equilibrium will get played when there are more than one Some games will have more than one equilibrium 6, 30, 0 3, 6 Baseball GameOpera Baseball Game Opera Player 2’s Action Player 1’s Action

13  Growth model  (Story)  Circle player 1’s best responses  Circle player 2’s best responses  Two equilibria: (invest, invest) and (consume, consume)  Some papers explain differences in growth across countries by saying some are in “good” equilibrium and some are in “bad” one Sometimes, there will be a “good” and a “bad” equilibrium 2, 20, 1 1, 01, 1 InvestConsume Invest Consume Player 2’s Action Player 1’s Action

14  Scissors, Paper, Rock for $1  Look for Nash Equilibria by circling best responses  No square with both payoffs circled  No equilibrium where each player plays a single action  In this class, we’ll focus on games with a pure-strategy Nash equilibrium Some games don’t have any equilibrium where players only play one action 0, 01, -1 -1, 10, 0 ScissorsPaper Scissors Paper Player 2’s Action Player 1’s Action -1, 1 1, -1 Rock 1, -1-1, 1 Rock 0, 0

15  Now on to… That’s a very quick introduction to static games

16 Property Law

17  In a sense, same question as, why do we prefer organized society of any sort to anarchy?  Suppose there are two neighboring farmers  Each can either farm his own land, or steal crops from his neighbor  Stealing is probably less efficient than planting my own crops  Have to carry the crops from your land to mine  Might drop some along the way  Have to steal at night  move slower  If I steal your crops, I avoid the effort of planting and watering Why do we need property law at all?

18  Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3  With no legal system, the game has the following payoffs:  We look for equilibrium  Like Prisoner’s Dilemma  both farmers stealing is the only equilibrium  but that outcome is Pareto-dominated by both farmers farming Why do we need property law? 10, 10-5, 12 12, -50, 0 FarmSteal Farm Steal Player 2 Player 1

19  Suppose there were lots of farmers facing this same problem  They come up with an idea:  Institute some property rights  And some type of government that would punish people who steal  Setting up the system would cost something  Suppose it imposes a cost c on everyone who plays by the rules So how do we fix the problem?

20 So how do we fix the problem? 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  If P is big, and c is not too big, then 12 – P < 10 – c  In that case, (Farm, Farm) is an equilibrium  Payoffs are (10 – c, 10 – c), instead of (0, 0) from before

21  Anarchy is inefficient  I spend time and effort stealing from you  You spend time and effort defending your property from thieves  Instead of doing productive work  Establishing property rights, and a legal process for when they’re violated, is one way around the problem So the idea here…

22  Cooter and Ulen: property is “A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others”  Property rights are not absolute  Appendix to ch. 4 discusses different conceptions of property rights  Any system has to answer four fundamental questions:  What things can be privately owned?  What can (and can’t) an owner do with his property?  How are property rights established?  What remedies are given when property rights are violated? Overview of Property Law

23  BUT…  Answers to many of these seem obvious

24  Pierson v. Post (NY Supreme Court, 1805)  Post organized a fox hunt, was chasing a fox  Pierson appeared “out of nowhere,” killed the fox, took it  Post sued to get the fox back  Lower court sided with Post; Pierson appealed to NY Sup Ct  Both were wealthy, pursued the case on principle or out of spite  Question: when do you own an animal? One early, “classic” property law case

25  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 Pierson v. Post

26 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 huting them the old-fashioned way is too dangerous

27 Next up: Coase

 Ronald Coase (1960), “The Problem of Social Cost”  In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency.  So the initial allocation of rights doesn’t matter for efficiency  However, it does matter for distribution  And if there are transaction costs, it may matter for efficiency too The Coase Theorem

 Your car – worth $3,000 to you, $4,000 to me  The key: lack of transaction costs An example of the Coase Theorem

 “In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency” Coase

Example from Coase – a rancher and a farmer

 Lots of examples from case law  a building that blocked air currents from turning a windmill  a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door  a doctor next door to a confectioner  a chemical manufacturer  a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller  In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation Other examples from Coase

Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved. In the case of the cattle and the crops, it is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops. The doctor’s work would not have been disturbed if the confectioner had not worked his machinery; but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place… Quoting from Coase (p. 13):

If we are to discuss the problem in terms of causation, both parties cause the damage. If we are to attain an optimum allocation of resources, it is therefore desireable that both parties should take the harmful effects into account when deciding on their course of action. It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties. Quoting from Coase (p. 13):

36  Please see me if you’re not yet registered  Take a look at Coase and Demsetz papers  Have a good weekend Tuesday: transaction costs