Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 6

1  Coase  Absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation  Two normative approaches to the law:  Normative Coase: aim to minimize transaction costs  Normative Hobbes: aim to allocate rights efficiently (or minimize the need for bargaining/trade)  How to choose between two normative approaches?  When transaction costs are low and information costs high, design law to minimize transaction costs  What transaction costs are high and information costs are low, design law to allocate rights efficiently Our story so far on property law…

2  Injunctive relief: court clarifies right, bars future violation; violations are punished as crimes (but right is tradable)  Damages: court determines how much harm was done by violation, awards payment to injuree  Coase: should be equally efficient if there are no transaction costs  But in “real world”, which is more efficient? One application of this: choosing a remedy for property rights violations

3 Calabresi and Melamed Transaction costs high…  difficult for parties to reassign rights through negotiations  injunction would force injurer to prevent harm himself  damages rule allows injurer to prevent harm or pay for it, whichever is cheaper  when transaction costs are high, damages rule is typically more efficient  “liability rule” Transaction costs low…  easy for parties to reassign rights  injunctions cheaper for court to implement (doesn’t need to calculate damage done)  when transaction costs are low, injunctive relief is typically more efficient  “property rule”

4 what can be privately owned? what can an owner do? how are property rights established? what remedies are given? How do we design an efficient property law system?

5 Public versus Private Goods Private Goods  rivalrous – one’s consumption precludes another  excludable – technologically possible to prevent consumption  example: apple Public Goods  non-rivalrous  non-excludable  examples  defense against nuclear attack  infrastructure (roads, bridges)  parks, clean air, large fireworks displays

6  When private goods are owned publicly, they tend to be overutilized/overexploited Public versus Private Goods

7  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied Public versus Private Goods

8  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

9  When private goods are owned publicly, they tend to be overutilized/overexploited  When public goods are privately owned, they tend to be underprovided/undersupplied  Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated Public versus Private Goods

10  Clean air  Large number of people affected  transaction costs high  injunctive relief unlikely to work well  Still two options  One: give property owners right to clean air, protected by damages  Two: public regulation  Argue for one or the other by comparing costs of each  Damages: costs are legal cost of lawsuits or pretrial negotiations  Regulation: administrative costs, error costs if level is not chosen correctly A different view: transaction costs

11 what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

12  Principle of maximum liberty  Owners can do whatever they like with their property, provided it does not interfere with other’ property or rights  That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else What can an owner do with his property?

13  What things can be privately owned?  Private goods are privately owned, public goods are publicly provided  What can owners do with their property?  Maximum liberty  How are property rights established?  (More examples to come)  What remedies are given?  Injunctions when transaction costs are low; damages when transaction costs are high So, what does an efficient property law system look like?

14 Up next: applications But first: an experiment

15  Each person given a personal value for a poker chip  Amount you can sell it back to me for (real money)  Purple chip is worth your number, red chip is worth 2 x your number  Each person can only sell back one chip  Take 1: buyer’s and seller’s values are common knowledge (nametags)  Take 2: private information (each player knows his threat point, but not his opponent’s) Experiment: Coasian bargaining

16  Take 3: uncertainty  If seller keeps chip, it’s worth 2 x die roll ($2-$12, EV $7)  If buyer gets chip, it’s worth 3 x die roll ($3-$18, EV $10.50)  Can’t sell for conditional price – deal must be done before die roll is revealed  Take 4: asymmetric information  Values are same as above…  …but seller knows value of die roll, buyer doesn’t Experiment: Coasian bargaining

17  Coase relies on parties being able to negotiate privately if the right is not assigned efficiently  Low-TC case: injunctions more efficient, assuming bargaining works if “wrong” party is awarded the right  How well does this work?  Last week: paper by Farnsworth showing no bargaining after 20 nuisance cases  Just saw examples of various transaction costs: private information, uncertainty, asymmetric information Why did we do this?

18 Sequential Rationality

19  Game theory we’ve seen so far: static games  “everything happens at once”  (nobody observes another player’s move before deciding how to act)  Dynamic games  one player moves first  second player learns what first player did, and then moves Dynamic games and sequential rationality

20 Dynamic games FIRM 1 (entrant) EnterDon’t Enter FIRM 2 (incumbent) AccommodateFight (10, 10)(-10, -10) (0, 30)  A strategy is one player’s plan for what to do at each decision point he/she acts at  In this case: player 1’s possible strategies are “enter” and “don’t”, player 2’s are “accommodate” and “fight”

21  We can look for equilibria like before  we find two: (Enter, Accommodate), and (Don’t Enter, Fight)  question: are both equilibria plausible?  sequential rationality We can put payoffs from this game into a payoff matrix… 10, 10-10, -10 0, 30 AccommodateFight Enter Don’t Enter Firm 2’s Action Firm 1’s Action

22 Dynamic games FIRM 1 (entrant) EnterDon’t Enter FIRM 2 (incumbent) AccommodateFight (10, 10)(-10, -10) (0, 30)  In dynamic games, we look for Subgame Perfect Equilibria  players play best-responses in the game as a whole, but also in every branch of the game tree  We find Subgame Perfect Equilibria by backward induction  start at the bottom of the game tree and work our way up

23  Firm 1 knows firm 2 is rational  So he knows that if he enters, firm 2 will do the rational thing – accommodate  So we enters, counting on firm 2 to accommodate  This is the idea of sequential rationality – the assumption that, whatever I do, I can count on the players moving after me to behave rationally in their own best interest The key assumption behind subgame perfect equilibrium: common knowledge of rationality