1. Econ 522 Economics of Law
Dan Quint
Fall 2011
Lecture 5

2. Homework First homework (efficiency) due midnight Thursday night
Dropbox folder on – upload any electronic file
me or Fran if you’re having problems
Second homework (property law) due in two weeks – midnight Thursday October 6

3. Monday…
Coase Theorem: in the absence of transaction costs, if property rights are well-defined and tradable, we’ll always get efficiency
Or: if property rights are complete enough, we can overcome externalities
Or: if conditions are perfect, initial allocation of rights doesn’t matter (for efficiency)
Demsetz: yes, but this comes at a cost
property rights will grow to cover more when gains from correcting externality exceed costs of administering more complex system
The Coase result only applies when there are no transaction costs
Today: transaction costs

4. Transaction Costs

5. What are transaction costs?
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
We’ve put off dealing with transaction costs until now, but it’s time to ask: what are transaction costs?
Transaction costs are anything that makes it difficult or expensive for two parties to achieve a mutually beneficial trade. Cooter and Ulen divide them into three categories:
search costs – difficulty in finding a trading partner
bargaining costs – difficulty in reaching an agreement on the terms of the trade
enforcement costs – difficulty in enforcing the agreement afterwards
Search costs are straightforward
When we think of common, standardized goods, there are likely lots of buyers and lots of sellers, so it shouldn’t be hard for them to find each other
When we think of rare or exotic goods, search costs may be very significant
(One of the most important effects of eBay might have been to lower search costs – if you want to buy some very specific, obscure thing, it makes it much easier for you to find some guy who’s selling it)
Enforcement costs are also pretty straight-forward
If I’m just buying an apple from a fruit stand, there are no enforcement costs – I give him my money, he hands me an apple, and the deal is done
But think about our example from before, of a rancher and a farmer
Suppose that even though the rancher is not liable for his herd’s damage, it’s cheaper for him to fence in his herd, so the farmer pays him to build a fence
But now the farmer has to make sure that he actually builds it, and maintains it – the deal is part of an ongoing relationship, and has long-term consequences
In the case of pollution rights, if a factory pays for the right to pollute a certain amount, or neighbors pay a factory not to pollute in excess, someone has to monitor the factory and make sure they abide by the agreement
This involves ongoing costs
Enforcement costs are any costs incurred after a deal is reached, to monitor or enforce the agreement

6. Bargaining costs come in many forms
Asymmetric information
Akerloff (1970), “The Market for Lemons” – adverse selection
We used the example before of your car being worth $3000 to you and $4000 to me
Once we find each other, all we have to do is haggle over price and agree on something in the middle – doesn’t sound so hard
However, this assumed that both of us knew exactly how we valued the car, and knew each others’ threat points
When these assumptions fail, things can get more complicated, for several reasons
First of all, I might worry that you know something about the car that I don’t
You’ve been driving it a while, so you might know that the transmission is about to fail, or that it needs new brake pads, or that it doesn’t start well on cold mornings
So I might worry that if you’re willing to sell it to me for $3500, maybe it’s because there’s something wrong with the car
So one aspect of bargaining costs might include taking it to a mechanic to verify its condition and try to get an objective measure of the value of the car
Famous paper by Akerloff, “The Market for Lemons,” dealing with this problem (adverse selection), showing that under some conditions, it can cause the market to fail completely
So one source of adverse selection is asymmetric information

7. Bargaining costs come in many forms
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
Next, even if we agree on the physical condition of the car, you might not be sure exactly how badly I want it
Suppose we both know the car is worth $3000 to you, but you don’t know what it’s worth to me – all you know is, I value it somewhere between $3000 and $5000
And suppose it turns out, I value it at $3200
Since I value it at more than $3000, there are gains from trade – it’s definitely efficient for you to sell me the car
But now I try to convince you that the car’s only worth $3200 to me, and that you should therefore sell it to you for $3100
But here’s the problem: anything that I say to try to convince you, I could also say if the car was actually worth $5000 to me
And you have no way of knowing whether I’m telling the truth or just haggling to get a better price
So if you give in and sell me the car for less than $3200, you can’t escape the possibility that you’d also give me that price if I valued it at $5000
So you say, “Maybe you’re telling the truth, and maybe you’re lying, but I won’t sell it for less than $4000.”
Which means that some of the time, even though I value the car more than you, we don’t reach a deal
There’s a famous paper by Roger Myerson and Mark Satterthwaite, “Efficient Mechanisms for Bilateral Trade,” which shows that when there’s private information of this sort, there is no way to guarantee that the efficient outcome will always be reached – there’s always some probability that an inefficient outcome (in this case, no trade) occurs
So a second source of bargaining costs: not knowing each others’ threat points

8. Bargaining costs come in many forms
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
There have been a number of papers on bargaining, both theoretical and experimental, that reinforce the fact that bargaining is more likely to fail if parties don’t know each others’ threat points
One interpretation of threat points being private information is simply that tastes are subjective – you don’t know how much I like the color of the car, for instance
But another source of uncertainty about threat points is when property rights themselves are ambiguous
Consider again the problem of the rancher and the farmer, and suppose that the efficient outcome is for the farmer to build a fence to protect his crops
But now suppose that the law is ambiguous – whether or not the rancher is liable for his crop’s damage is open to interpretation, or depends on the exact details of the situation, so the court’s decision is unpredictable
In that case, the rancher and the farmer might not agree on what would happen if no fence was built; and so each one might be uncertain about the other one’s threat point, and therefore it might be very hard for them to come to an agreement
This is one of the arguments for clear, simple, well-defined, unambiguous property rights – that they make negotiations easier, that is, effectively lowering transaction costs.

9. Bargaining costs come in many forms
Large numbers of parties
Developer values large area of land at $1,000,000
10 homeowners, each value their plot at $80,000
There’s another way in which bargaining can be difficult, or even impossible, which is when instead of a single buyer and a single seller, there are many parties to the deal
Suppose there’s a developer, who wants to build a shopping mall, and he values the land he wants to build on at $1,000,000
Now suppose there are currently 10 houses on that land, and each homeowner values his property at $80,000
Clearly, there are gains from trade: the combined value of the plots is $1,000,000 to the developer, and $800,000 to their current owners.
But now think about one of the homeowners
He thinks, “If we all sell our land to the developer, this creates $200,000 of surplus. I don’t mind if all my neighbors sell out cheaply, but I want a piece of that!”
And he figures that he’s the only one smart enough to ask for more money, so he asks for $120,000, figuring that still leaves the developer with a big enough surplus
But now some of his neighbors do the same calculation, and ask for more money for their land
And since it’s very hard to negotiate with 10 people at the same time, negotiations may fail.
(One of the papers I’m working on is a game-theory model of many-to-one bargaining. The idea is this.
Everyone accepts that if 9 of the homeowners have sold out to the developer, the last guy is in a pretty strong bargaining position, so he can probably get a pretty high price for his property
But since everyone knows that, nobody wants to be the first to sell out – they’d rather wait for their neighbors to sell, and then be the last, so they get a better price
So even when cooperation, or trade, is efficient, and might occur eventually, there can be huge delays before the trade happens, due to everyone waiting around hoping to be last.)

10. Bargaining costs come in many forms
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
And the same thing can happen when there are many buyers instead of many sellers
Suppose that instead of a shopping mall, the land was being bought up to be turned into a park, that would benefit 10,000 people in the community, and each of them would receive benefits worth $100 from the joy of having the park
Even if the homeowners were all willing to sell for $80,000, or $800,000 total, it might be impossible to raise that much through voluntary contributions, since each citizen might think, “We only need to raise $800,000, and all my neighbors should be willing to pay $100, so even if I don’t pay anything, the park should get built!”
This is the problem of freeriders – once the park is built, its use won’t be limited to the people who paid for it, so people may try to avoid paying, preferring to get the benefits for free.
So when negotiations need to take place between lots of people, rather than just one buyer and one seller, there is a risk of holdout – individual sellers holding out for high prices – and freeriding – individual buyers trying to get the good for free
Either of these could cause negotiations to fail, or to take a long time to conclude
And even if negotiations go smoothly, it’s costly to negotiate with lots of individuals
Arthur Pigou, on railroads and sparks
So another source of bargaining costs is having lots of individuals to negotiate with
One final source of bargaining costs is hostility
I’ll come back to this next week
Many divorce agreements end up being settled by litigation, which is more costly than negotiation, not because the parties disagree about their threat points or for any other rational reason, but because the parties are angry with each other and don’t want to come to a rational agreement

11. Sources of transaction costs
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

12. So, what do we do?

13. What we know so far…
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
So now, let’s recap what we know
Coase tells us that when there are no transaction costs, the initial allocation of property rights (or liability) doesn’t matter for efficiency, since people will trade until efficiency is reached
On the other hand, when transaction costs are high, the initial allocation is important, since trade may not be feasible (and even if it is feasible, it’s costly)
This leads to two different notions of what the goal of property rights should be, that is, two different normative approaches we could take to designing property law.

14. Two normative approaches to property law
Design the law to minimize transaction costs
“Structure the law so as to remove the impediments to private agreements”
Normative Coase
“Lubricate” bargaining
Structure the law to minimize transaction costs.
Cooter and Ulen phrase this as, “structure the law so as to remove the impediments to private agreements,” and refer to this as the Normative Coase approach
If the law is able to reduce transaction costs, then voluntary exchange will be more likely to lead to efficiency
The textbook also refers to this as “lubricating” bargaining – making it easier for bargaining to proceed without costs.
We said before that one source of bargaining costs is uncertainty about threat points
This suggests that bargaining costs are reduced when the law is simple and unambiguous, so that everyone is clear about everyone’s rights
This seems to favor rules like fast fish/loose fish and allocating the fox to Pierson, the guy who actually killed it – these are simple rules, there is little to dispute once the rule is established, and this should make both sides’ threat points clear and encourage trade to occur when it is efficient.

15. Two normative approaches to property law
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
However, this is not the only possible goal of the law. Like we said, when transaction costs are high, the initial allocation matters for efficiency; so a different conception of the goal of the law could be,
Structure the law so as to minimize the harm caused by failures in private agreements.
Or really, structure the law to make the allocation as efficient as possible to begin with, so that fewer negotiations are required and their failure is less costly.
This goal was put forward by Hobbes, who felt that people could not be counted on to be rational enough to cooperate
Cooter and Ulen call this view of the law the Normative Hobbes approach
It suggests that the law should aim to allocate property rights to whoever values them the most, so that transaction costs become irrelevant, trade is unnecessary, and efficiency is achieved no matter what
This may require more complicated laws
What’s efficient may be different in different situations, so the law will have to be different in different situations  more complicated

16. Which approach should we use?
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
So now we have two possible ideas of what property law should aim to accomplish
one, lubricate private transactions
or two, allocate rights to whoever values them more
so now we have to ask, when is one of these aims appropriate and when is the other?
we can answer this by thinking about the cost of each rule
When transaction costs are reduced, they are still unlikely to be eliminated
That is, lubrication works up to a point, but there will still be some transaction costs remaining
When these are low, efficiency will nearly be achieved; when they are still high, the outcome may still be very inefficient.
On the other hand, in order to start out at an efficient allocation, lawmakers have to figure out who values a right more highly
This is not always obvious
So we can imagine the lawmakers must face some sort of Information Costs to come to the correct conclusion
(This can be thought of either as costs they actually incur in researching the situation, or as the costs of being wrong some of the time.)
Which brings us to the principle reached by Cooter and Ulen:
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

17. Designing an efficient property law system

18. Four questions we need to answer
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
We said that any property rights system must address four questions:
What things can be privately owned?
What can (or can’t) an owner do with his/her property?
How are property rights established?
And what remedies are given when they are violated?
Next, we want to answer each of these, with an eye toward efficiency
That is, how would an efficient property system answer each question?
We begin with one we haven’t yet considered at all: remedies
And we begin with an important paper (on the syllabus), by Calabresi and Melamed

19. Calabresi and Melamed treat property and liability under a common framework
Calabresi and Melamed (1972), Property Rules, Liability Rules, and Inalienability: One View of the Cathedral
Liability
Is the rancher liable for the damage done by his herd?
Property
Does the farmer’s right to his property include the right to be free from trespassing cows?
Entitlements
Is the farmer entitled to land free from trespassing animals?
Or is the rancher entitled to the natural actions of his cattle?
we begin today with an important paper from 1972 by Guido Calabresi and Douglas Melamed, titled, “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral”
the topic of the is how property rights are enforced, that is, what remedies are used when rights are violated
Calabresi and Melamed state that their goal is to treat both property and liability law under a common framework, rather than keeping them as distinct topics
we’ve already been doing this
when we think about the rancher-farmer question, we can pose it in terms of liability – is the rancher liable for the damage his herd does?
or we can pose it in terms of property – does the farmer’s right to his property include the right to be free from trespassing cows? or does the rancher’s right to his herd include the right to not be punished when they stray?
Calabresi and Melamed were the first to consider both property and liability in the same terms
They consider both cases to be cases of “entitlements”
is the farmer entitled to land without trespassing animals, or is the rancher entitled to be free from herd-damage liability?
Similarly, are you entitled to have a noisy party, or am I entitled to get a good night’s sleep?

20. Three possible ways to protect an entitlement
Property rule / injunctive relief
Violation of my entitlement is punished as a crime
(Injunction: court order clarifying a right and specifically barring any future violation)
But entitlement is negotiable (I can choose to sell/give up my right)
Property Rules, or Injunctive Relief
This is when you are legally barred from violating my entitlement without my prior agreement
This is the usual rule for protecting private property – if it’s mine, you simply can’t take it unless I give it to you
And if you do choose to take it, you’ve committed a crime – you don’t just owe me the value of what you took, you may go to jail, you may face other severe consequences
(the idea of a property rule is that the punishment is so severe, you’ll never choose to violate my right without my permission)
An injunction is basically a court order clarifying someone’s rights and specifically barring someone from violating them
For example, if a factory is polluting and the neighbors object and take it to court, the court might issue an injunction, which would bar the factory from further pollution
The factory could still negotiate with the neighbors and reach some bargain where the neighbors agree not to enforce the injunction, but this would be completely at the discretion of the neighbors

21. Three possible ways to protect an entitlement
Property rule / injunctive relief
Violation of my entitlement is punished as a crime
(Injunction: court order clarifying a right and specifically barring any future violation)
But entitlement is negotiable (I can choose to sell/give up my right)
Liability rule / damages
Violations of my entitlement are compensated
Damages – payment to victim to compensate for damage done
Inalienability
Violations punished as a crime
Unlike property rule, the entitlement cannot be sold
Liability Rules, or Damages, is when you can violate my entitlement without my agreement, but must compensate me afterward for whatever damages I incur
under a liability or damages rule, the factory could go on polluting, and the neighbors would sue them for damages
the court would then have to calculate an objective value of the damage done
the neighbors can argue that the damage incurred was high, but they are only awarded what is considered fair value, not what they argue they would have held out for in the beginning
This is the type of rule behind eminent domain, which we’ll talk about in a bit
if the government wants to build a school, or an army base, or a town dump, on land that I own, they can force me to sell my land
and they can force me to sell at what is considered fair market value, not to hold out for whatever amount I want based on my sentimental attachment to the house I grew up in or anything else
Liability rules obviously work better than property rules in settings where prior negotiation is impossible
Clearly, I have an entitlement to not be hit by someone’s car when I’m walking, but it’s hard to imagine them approaching me beforehand and bargaining for the right to hit me.
The difference: damages are backward-looking – they compensate for harm already done, while injunctions and property rules are forward-looking – they specifically forbid future harms from occurring.
Third way to protect an entitlement – Inalienability – we’ll come back to later

22. Comparing property/injunctive relief to liability/damages rule
Injuree (person whose entitlement is violated) always prefers a property rule
Injurer always prefers a damages rule
Why?
Punishment for violating a property rule is severe
If the two sides need to negotiate to trade the right, injurer’s threat point is lower
Even if both rules eventually lead to the same outcome, injurer may have to pay more
We know from Coase that either rule should lead to an efficient outcome if transaction costs are low
But they may still lead to different outcomes – the rules will favor different sides
In particular, a property rule will always be more favorable toward the injuree (the person whose entitlement is to be violated), and a liability rule will always be more favorable toward the injurer
This is because the punishment for violating an injunction without the other side’s permission is much harsher than damages – it may involve criminal trespass or violating a court order
So when the two sides bargain, the injurer will have a much lower threat point when facing an injunction, so the injuree will end up with a higher payoff if they do choose to cooperate
(We’ll see an example.)
We know from Coase that in a world without transaction costs, either rule should be sufficient to allow private bargaining to lead to efficiency
However, since the two rules give the two sides different threat points, they change the payoff achieved by each side during negotiations
In a world with transaction costs, of course, one may lead to a more efficient outcome than the other

23. Comparing injunctive relief to damages – example
E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100
Comparing injunctive relief to damages – example
Electric company E emits smoke, dirties the laundry at a laundromat L next door
E earns profits of 1,000
Without smoke, L earns profits of 300
Smoke reduces L’s profits from 300 to 100
E could stop polluting at cost 500
L could prevent the damage at cost 100
Consider the example in Cooter and Ulen
There is an electric company E that emits smoke, which dirties the laundry at a laundromat L next door
The electric company earns profits of 1000
Without smoke, the laundromat earns profits of 300.
Smoke does $200 of damage (reducing profits to 100)
The electric company could stop emitting smoke by installing scrubbers in its smokestack, at a cost of 500.
The laundromat could also avoid the damage by installing filters on its ventilation system, at a cost of 100.

24. First, we consider the non-cooperative outcomes
E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100
First, we consider the non-cooperative outcomes
Polluter’s Rights (no remedy)
E earns 1,000
L installs filters, earns 300 – 100 = 200
Laundromat has right to damages
E earns 1,000, pays damages of 200  800
L earns 100, gets damages of 200  300
Laundromat has right to injunction
E installs scrubbers, earns 1,000 – 500 = 500
L earns 300
First, we’ll consider the non-cooperative outcome, that is, what happens when the two sides do not try to negotiate with each other
Given the remedies we’re considering right now, there are three possibilities
the electric company is allowed to pollute with no consequences;
the laundromat is entitled to damages;
or the laundromat can get an injunction preventing pollution

25. Noncooperative payoffs
E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100
Noncooperative payoffs
Polluter’s Rights
Damages
Injunction
E payoff (non-coop)
1,000
800
500
L payoff (non-coop)
200
300
300
Combined payoff (non-coop)
1,200
1,100
800
Clearly, the efficient outcome is for L to install filters, leading to combined profits of 1200
(This avoids $200 in damage at a cost of $100, and is the cheapest way to avoid the damage.)
This is the outcome that occurs in the Polluter’s Rights case
(No reason this should be true generally, just in this example)
In the other two cases, the noncooperative outcome is inefficient
But if there are not transaction costs, the two sides could still negotiate an agreement to achieve efficiency
But in each case, the threat points would be different, so the division of surplus will be different under the different rules.

26. What about with bargaining?
E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100
What about with bargaining?
Polluter’s Rights
Damages
Injunction
E payoff (non-coop)
1,000
800
500
L payoff (non-coop)
200
300
300
Combined payoff (non-coop)
1,200
1,100
800
Gains from Coop
100
400
But now, suppose there are no transaction costs, and the electric company and laundromat owners are able to negotiate with each other
Clearly, the efficient outcome is for the laundromat to install air filters – this prevents the damage the cheapest way possible, and leads to the highest combined payoffs
So if the two sides bargain, that’s the outcome they’ll reach
In the polluter’s rights case, this is already the outcome – they have nothing to bargain over
But in the other two cases, they do
In the case of damages, the noncooperative outcome is inefficient – the electric company is paying $200 for damage that could be prevented for $100, so there are $100 in gains from trade
If we imagine the gains from trade are divided equally, each side will end up with $50 more than their threat point
In the case of injunction, the gains from trade are even bigger – now they create $400 in new surplus by bargaining
If this gets divided equally, the payoffs are 700 and 500
What does Coase say? That the bottom row are all the same – regardless of the initial allocation, bargaining leads to the efficient outcome
BUT, the two sides care very much about the initial allocation
The more favorable the initial rule is to the electric company, the better he does in the end; and the more favorable the initial rule is to the laundromat, the better he does in the end
E payoff (coop)
1,000
850
800 + ½ (100)
700
500 + ½ (400)
L payoff (coop)
200
350
300 + ½ (100)
500
300 + ½ (400)
Combined
1,200
1,200
1,200

27. Comparing injunctions to damages…
Injunctions are generally cheaper to administer
No need for court to calculate amount of harm done
“No remedy” isn’t usually a good answer, so let’s compare the other two – injunctions versus damages
An injunction is cheaper for a court to implement
the court simply clarifies the property right; it does not have to calculate the exact amount of damage that was done
damages are more difficult for a court to implement, since they must assess the monetary value of damage that was done
(We’ll return to the question of how damages are computed when we get to tort law; but for now, just realize this requires going to court, expert testimony, and a judgment.)

28. Comparing injunctions to damages…
Injunctions are generally cheaper to administer
No need for court to calculate amount of harm done
Damages are generally more efficient when private bargaining is impossible
Three possibilities: injurer prevents harm, injuree prevents harm, nobody prevents harm (someone pays for it)
Efficiency: cheapest of the three
Damages: injurer can prevent harm or pay for it;
injurer chooses whichever is cheapest
Injunction: injurer can only prevent harm
Damages lead to better outcomes when transaction costs are high, that is, when bargaining is impossible (or likely to fail). Why?
For efficiency, in any given situation, we want to end up at whichever of these three alternatives is the cheapest (has the lowest cost)
With no transaction costs, the Coase Theorem tells us this is what will happen, regardless of the initial rule
But suppose transaction costs are high – private negotiation is impossible, so whatever rule we set, that’s the rule that holds
Under damages, the injurer is responsible, but he has two options: prevent the harm, or pay for the harm
The injurer will choose whichever is cheaper to him (lower private cost)
But with damages, the injuree is indifferent between the two – the laundromat doesn’t care whether the harm is avoided, or whether he sustains $200 in harm and then gets a check for $200 in damages
Which means the injurer is no longer imposing an externality; so when he chooses between preventing the harm and paying for it, he chooses whichever is more efficient
But under an injunction, the injurer would be forced to prevent the harm, even if that’s more expensive than just paying for it afterwards
In the example we just saw, the electric company would have to install $500 scrubbers to prevent $200 worth of harm
Under a damages rule, the electric company could just pollute and then pay $200 in damages
(Still less efficient than having the laundromat install filters, but less inefficient…)
So when private negotiations are impossible – when transaction costs are high – damages lead to a more efficient outcome

29. So now we know… Any rule leads to efficient outcomes when TC are low
Injunctions are cheaper to implement
Damages lead to more efficient outcomes when TC high
Leads Calabresi and Melamed to the following conclusion:
When transaction costs are low, a property rule (injunctive relief) is more efficient
When transaction costs are high, a liability rule (damages) is more efficient
But which rule is more efficient in general?
First of all, “no remedy” can’t be the right answer, so we’re really comparing injunctions to damages
An injunction is cheaper for a court to implement
the court simply clarifies the property right; it does not have to calculate the exact amount of damage that was done
damages are more difficult for a court to implement, since they must assess the monetary value of damage that was done
(We’ll return to the question of how damages are computed when we get to tort law; but for now, just realize this requires going to court, expert testimony, and a judgment.)
However, in this example, if private bargaining fails, damages lead to a more efficient result than an injunction, and this turns out to be true more generally
We’ll talk more about why in a minute
This leads Calabresi and Melamed to the following conclusion:
When transaction costs are low (or private negotiations can be expected to succeed), a property rule (or injunctive relief) is more efficient
When transaction costs are high (or there are impediments to private negotiations), a liability rule (damages) is more efficient
This agrees with the rule we came up with a little while ago
When TC are low, we should default to the Normative Coase: design the law to lower them even further
In this case, that means a property rule, which is cheaper to implement and clarifies rights to “lubricate” bargaining
When TC are high, default to the Normative Hobbes: design the law to allocate rights more efficiently
In this case, that means a damages rule

30. High transaction costs  damages Low transaction costs  injunctive relief
“Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy.
On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.”
(Cooter and Ulen)
Cooter and Ulen point out that in a wide range of cases, this is how things are actually done
“Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy.”
On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.
But, in the first case – where transaction costs are high, so bargaining is likely to fail – a liability rule is only efficient when the court is able to correctly calculate the amount of damages
(Damages get the injurer to internalize his externality – he pays the cost that he imposes on the injurer – but if damages are calculated wrong, he pays the wrong cost, and so he won’t behave efficiently)
On the other hand, injunctive relief is efficient any time the court can determine who values the right more, regardless of its absolute level
(If the court assigns the right to the correct party, no bargaining is necessary)
This leads Cooter and Ulen to a different interpretation of efficient remedies in the case of high transaction costs:

31. A different view of the high-transaction-costs case…
“When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely.
Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.”
(Cooter and Ulen)
This leads them to a different interpretation of efficient remedies in the high-transaction-costs case:
When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely.
Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.
For example: suppose the court knows that a good night’s sleep is worth exactly $200 to me. Then it can protect this right be damages; then you’ll only have a party if having the party is worth more than $200 to you, since that’s what you’d have to pay me; and this is exactly what’s efficient.
On the other hand, suppose the court has no idea what a good night’s sleep is worth to me, but knows it’s worth more to me than having a party is to you. The court can’t use damages, since it won’t know how much damages to assess; but it can give me an injunction against noise, and then you won’t be able to have the party, which is efficient in this case.

32. Low transaction costs  injunctive relief
Cheaper for the court to administer
With low transaction costs, we expect parties to negotiate privately if the right is not assigned efficiently
But… do they really?
Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral
20 nuisance cases: no bargaining after judgment
“In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining…
Frequently the parties were not on speaking terms...
…The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.”
In the case where transaction costs are low, however, injunctive relief is assumed to be more efficient
because it is cheaper for the court to implement
and because, by making property rights clear, it is more likely to encourage negotiations
Calabresi and Melamed defend injunctions as being optimal by assuming that the parties will privately negotiate after the court rules
Cooter and Ulen (on their website) mention a paper by Ward Farnsworth, examining whether this occurs.[1]  Quoting:
Farnsworth "examines twenty nuisance cases and finds no bargaining after judgment in any of them; nor did the parties’ lawyers believe that bargaining would have occurred if judgment had been given to the loser.
Farnsworth asked the lawyers why they though that no bargaining occurred after judgment.  The lawyers cited two impediments to post-judgment bargaining.
"First, in almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining.  The parties in these cases often thought that their adversaries were behaving in ways that were unreasonable, discourteous, and unneighborly.  Frequently the parties were not on speaking terms by the time the case was over (sometimes much earlier).  ... 
The second recurring obstacle involves the parties’ disinclination to think of the rights at stake in these cases as readily commensurable with cash."  
[1] Ward Farnsworth, “Do Parties to Nuisance Cases Bargain After Judgment?  A Glimpse Inside the Cathedral,” 66 U. Chi. L. Rev. 373 (1999). 

33. Third way to protect an entitlement: inalienability
Inalienability: when an entitlement is not transferable or saleable
Allocative externalities (enriched uranium)
As the title of the paper suggests, Calabresi and Melamed also talk about a third way to protect entitlements: inalienability
This is when violation of my entitlement is punished as a crime, like with property laws;
but the entitlement is not seen as property, because it cannot be sold
(In some cases, it’s legal to give away the entitlement, just not for money; in other cases, you can’t even give it away.)
From a Coase point of view, this doesn’t make sense. We said Monday that to achieve efficiency, we should let people trade; now we’re not letting them.
But there are a few instances where prohibiting trade may make sense.
The first is when the allocation of rights imposes an externality
We said earlier, efficiency means every resource is owned by whoever values it the most
But this is only literally true if ownership of this resource does not impose any externalities
If it does – if other people care whether you or I own your car – then it’s more complicated
Example: I’m a nuclear physicist, and I have some enriched uranium left over from an experiment
It’s worth very little to me
Along comes a terrorist, who wants to turn it into a dirty bomb and blow it up in a major city
He’s very determined, and has a lot of money; so the uranium is worth more to him than it is to me
Is it efficient for him to have it?
No, because if he gets it, this imposes a big negative externality on lots of other people (his victims)
So what does Coase say?
Well, in the extreme Coasian view, where there are no transaction costs, there’s still no problem
Because everyone else effected by the sale – all his potential victims, their families, etc. – could take up a collection to pay me not to sell the uranium to this terrorist
And if it’s truly efficient for him not to get it, they could theoretically raise more money than he’s willing to pay, to stop the sale
In the real world, however, this is obviously impossible, for many reasons
So the law takes the simple solution: just makes it illegal for me to sell the uranium at all

34. Third way to protect an entitlement: inalienability
Inalienability: when an entitlement is not transferable or saleable
Allocative externalities (enriched uranium)
“Indirect” externalities (human organs)
I’ll give another example where inalienability may be appropriate not because of a direct externality, but because of an indirect one: human organs
Specifically, kidneys
Human beings are born with two kidneys, but only need one to live a happy, healthy life
On the other hand, people can’t live without a functioning kidney; but people with kidney disease can live a long, healthy life after receiving a new kidney via transplant
So there are lots of potentially Pareto-improving trades, whereby people with two good kidneys give up one to someone who needs it
This does happen, but it doesn’t happen as much as it could: in 2004, about 15,000 kidney patients received transplants (more than half from dead bodies), but 60,000 more people were waiting for a kidney
Part of the reason for the shortage is that in the U.S., it’s illegal to financially compensate the donor
So, the economist would say, there’s a price cap – the price is legislated to be zero, less than the market-clearing price, so there’s excess demand
If people were allowed to buy and sell kidneys, there would presumably be a market-clearing price – those who needed one, and could afford it, would get one; donors would be willingly giving up an organ, so presumably they’re better off as well; it’s hard to see how outside parties are directly effected, so there don’t seem to be substantial externalities
So what’s the problem?
Well, here’s one.
Today, suppose you pull someone into an alley and beat them to death with a crowbar
You get their wallet and cell phone – nice, but probably not enough to make it worth the risk
Imagine a world where human organs are sold freely
Now if you pull someone into an alley and beat them to death, you can sell all their organs for perhaps hundreds of thousands of dollars
All of a sudden, because we’ve allowed these transactions, perhaps the murder rate goes up

35. Third way to protect an entitlement: inalienability
Inalienability: when an entitlement is not transferable or saleable
Allocative externalities (enriched uranium)
“Indirect” externalities (human organs)
Paternalism
So in some instances where entitlements are inalienable, there are good reasons – either direct or indirect externalities that might be hard to solve in other ways
But in many cases, I think, inalienability is simply a case of governmental paternalism – legislators believing they know what’s right for people, and trying to impose their view of morality or “correct” behavior through laws
This is how I think about laws governing the drinking age, or prohibiting certain drugs, or laws about gambling – they’re defended on grounds of externalities, but to me, they’re usually more an issue of government trying to ban behavior it doesn’t like
Which is not to say the government is always wrong.
Here’s a recent story from China. A 17-year-old boy wanted an iPad 2 but could not afford it, so he contacted a black-market organ broker and sold one of his kidneys for 20,000 yuan, about $3400.
Turns out, the boy’s parents didn’t know until afterwards; the hospital where the surgery was done wasn’t really qualified to do it; and not surprisingly, the broker has disappeared
Unfortunately, now the boy is having health problems related to the surgery and regrets it, but it’s too late to do anything
So maybe sometimes the government is right to try to ban certain types of transactions
source: National/2011/06/02/Boy%2Bregrets%2Bselling%2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/

36. what can be privately owned? what can an owner do?
how are property rights established?
what remedies are given?
We’ve now addressed the fourth question, remedies
Wednesday, we’ll attack the other three questions of how you design an efficient property law system in theory, and then move on to applications.