Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 4

1  Last lecture, we…  introduced static games, the matrix representation of payoffs, and how to find equilibria  motivated the need for property law (“anarchy is inefficient”)  Today…  the Coase Theorem Outline

2 Coase

3  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

4  Your car – worth $3,000 to you, $4,000 to me  If I start out owning the car: no reason for you to buy it, I end up with it  efficient  If you start out owning the car: clear incentive for me to buy it, I end up with it  efficient  I’d rather start with it, you’d rather start with it…  …but either way, we get to the efficient outcome  The key: lack of transaction costs An example of the Coase Theorem

5  “In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency”  You want to have a party next door to my apartment  Think of “party rights” like an object  I start off with “party rights” (right to be undisturbed): You can buy them if they’re worth more to you (and your guests)  You start off with party rights (right to have party): I can buy them if quiet is worth more to me than party is to you  Whoever starts with them, we still get to efficiency Coase

6 Example Coase uses: a rancher and a farmer

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8  Three possibilities:  Rancher builds fence around herd… $400  Farmer builds fence around crops… $200  Do nothing, live with damage… $0  If expected damage = $100…  If expected damage = $500… Example: rancher and farmer

9  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

10 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):

11 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 desirable 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):

12  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…  …although it does matter for distribution…  …and it may matter for efficiency if there are transaction costs So, summing up…

13 Bargaining

14  Example from before:  Your car is worth $3,000 to you, and $4,000 to me  Suppose I have $10,000  $10,000 is my threat point  the payoff I can get on my own, by refusing to cooperate with you  also called reservation utility, or outside option  $3,000 is your threat point  Any outcome we both agree to must make us both at least as well-off as our threat point Some vocabulary about bargaining

15  If I don’t buy the car from you…  my payoff is 10,000 (my threat point)  your payoff is 3,000  combined payoffs are 13,000  If I buy the car for some price P  my payoff is 4, ,000 – P = 14,000 – P  your payoff is P  combined payoffs are 14,000 – P + P = 14,000  $1,000 are the gains from trade (or gains from cooperation)  no trade  combined payoffs of $13,000  I buy car  combined payoffs of $14,000  if we cooperate, our combined payoffs increase by $1,000 Some vocabulary about bargaining

16  Threat points: 10,000 and 3,000  Gains from cooperation: 1,000  If gains from cooperation were divided equally…  we’d each get 500 more than threat point  my payoff would be 10,500, yours 3,500  Which means P = $3,500  (Coase doesn’t say gains will be divided equally, just that they’ll be divided in some way) Some vocabulary about bargaining

17  Cows do $500 damage; fence around herd costs $400; fence around crops costs $200 Let’s go back to the rancher and farmer -200 Combined Payoffs Farmer’s Payoff -3000Rancher’s Payoff (IF…) 2000Gains From Cooperation 0-200Farmer’s Threat Point -4000Rancher’s Threat Point Farmer’s RightsRancher’s Rights

18  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

19  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

20 Demsetz

21 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

22  “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”

23  “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: medium  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”

24  “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: medium  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”

25 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”

26 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”

27 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”

28  Coase: if property rights are complete and tradeable, 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… So…

29 Transaction Costs

30  Coase: “in the absence of transaction costs, if property rights are well-defined and tradeable, 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 So…

31 “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 as we have seen, 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…

32  “In the absence of transaction costs, if property rights are well-defined and tradeable, 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

33 What Are Transaction Costs?

34  What are transaction costs?  What do we do about them? Up next: