Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 7.

Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 7

Logistics HW2 online, due in two weeks (Thurs Oct 10, 11:59 p.m.)
First midterm is Wednesday October 23 Midterms will be in different room – Education L196 Starting next week, Nathan’s office hours are switched Mondays 4-5 and Wednesdays 1-2

Example of Coasian bargaining I found yesterday
source:

Monday, we “tested the Coase Theorem”
Can UW undergrads reallocate poker chips efficiently? (Cost me $172 to find out) What happened?

actual final allocation fraction of potential gains realized
Our experiment… Take 1: Full Information (values on nametags) starting allocation efficient allocation actual final allocation fraction of potential gains realized 12 red chip red chip 10 purple chip purple chip 10 purple chip purple chip 8 red chip purple chip purple chip 8 purple chip purple chip So much to talk about! (Group allocated efficiently, split money evenly, including some one started with more!) “Homo econonomicus” – the modeling assumption that people are selfish – is an abstraction Not a normative statement – there’s nothing “wrong” or immoral with being altruistic and sacrificing own payoff for others Assuming selfishness is a modeling convenience – tends to lead to better predictions in many situations, but not perfect! I joked about my class being full of socialists Main critique of socialism is not that there’s something wrong with everyone getting equal allocations But that if you tell everyone that stuff will be divided equally, there ends up being less stuff (We saw this with corn collectivism example from Pilgrims – when we had to share output, nobody wants to work hard) In this case, people were able to separate efficiency from distribution That is, they were able to maximize the total “output”, then divide it equally So… good job! The other point goes back to a book I mentioned one day 1, Ellickson, “Order Without Law” There are things other than what you’re legally entitled to that govern behavior Social norms, ideas of what it means to be a good neighbor, or a good person, or a friend In this case, one person was “legally entitled to” keep $16, but chose to go in with the group Whether because people were watching, or because he wanted to be nice, or because it felt right In this class, we mostly assume people are rational and self-interested; but in the real world, that is often mostly right, not always 100% right 6 purple chip 6 4 purple chip 4 purple chip 2 purple chip 32 60 60 100%

actual final allocation fraction of potential gains realized
Our experiment… Take 2: Private Information (values hidden) starting allocation efficient allocation actual final allocation fraction of potential gains realized 10 red chip red chip 8 purple chip purple chip 8 purple chip purple chip 6 red chip purple chip 6 purple chip purple chip 4 purple chip purple chip 4 3 purple chip 3 purple chip 2 purple chip 24 48 46 22/24 = 92%

Our experiment… Take 3: Uncertainty Take 4: Asymmetric Information
All three chips got sold, at prices around $8 Rolls were 3, 5, and 6, so buyers all made money… …but trade would still have been efficient if they hadn’t And we achieved 100% of gains from trade Take 4: Asymmetric Information Rolled 6 and 6 Nobody traded So we achieved 0% of gains from trade

Conclusion Coase seems to work pretty well, except when there’s asymmetric information Full info: 100% of gains achieved Private info: 92% of gains Uncertainty: 100% Asymmetric info: 0%

Observation: information can be bad for the person who has it!
Consider a seller in the last two cases Your value = 2 x die roll, EV = $7.00 If you know nothing… Trade at some price between $7 and $10.50 Expected payoff might be $8 If you know value exactly… Asymmetric information might mean you can’t sell If so, expected payoff is $7 So information can have negative value! In decision problems, we always think of information being good – it helps you make a better decision, and you’re always free to ignore it if you think it hurts you But in strategic settings, where other people know you have information and react to that fact, having more information can make you worse off!

Back to property law…

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? Monday, we had mostly settled the question: what remedy should we use?

Our conclusions (from Calabresi/Melamed)
When transaction costs are low, use injunctive relief Either rule will lead to efficient allocation (Coase)… …but injunctions are cheaper to implement (court doesn’t have to assess level of harm) When transaction costs are high, use damages If bargaining is impossible, damages  more efficient outcomes (Example: polluter can choose to pollute and pay when that’s more efficient than preventing the damage) Agrees with principle from textbook TC low: design law to facilitate trade (normative Coase) TC high: design law to not rely on bargaining (normative Hobbes) 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 11 11

So, do we buy it? Coase Theorem depends on parties being able to negotiate privately Low-TC case: injunctions more efficient, assuming bargaining will work if “wrong” party is awarded the right Does it really work? Our experiment showed asymmetric information can prevent trade For more evidence… 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 12 12

So, do we buy it? 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.” So “no TC” case may be rare in real life… 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). 13 13

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.) Kidneys, sex, cocaine, babies, votes, nuclear weapons, unlicensed legal advice 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 14 14

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 15 15

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/ 16 16

Another interpretation of inalienability: bans on “repugnant markets”
markets that are illegal because people find them morally or aesthetically objectionable CA ban on serving horse and dog meat Paying birth mother to adopt a child Bans on dwarf tossing Ticket scalping, price gouging, gambling, drugs, prostitution Roth: repugnance an important constraint on markets What people find repugnant changes over time Charging interest used to be repugnant! Repugnance has to be considered in practical market design 2012 Nobel Prize winner Al Roth We just discussed inalienability as referring to certain entitlements that can’t be sold – or certain transactions that aren’t allowed I gave a couple examples of markets with externalities, where such a ban might make sense But there’s another interpretation for why certain types of transactions aren’t allowed – which is repugnance Roth (in “Repugnance as a Constraint on Markets”, Journal of Economic Perspectives 21(3), Summer 2007) writes, “Many Californians not only don’t wish to eat horses or dogs themselves, but find it repugnant that anyone else should do so, and they enacted this repugnance into California law… in 1998.” Dwarf tossing

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’ll start with the first one

Public versus 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 You may recall from micro a discussion of Public and Private Goods. Private Goods tend to be characterized by two properties: Rivalrous – one person’s consumption of a private good precludes another person’s enjoyment of its benefits if I eat an apple, you won’t be able to eat that same apple Excludable – it’s technologically possible to prevent others from consuming it It shouldn’t be too hard for me to prevent you from eating it. Public Goods tend to be characterized by the opposite of these two properties: Nonrivalrous – one person’s consumption of a public good does not impact others’ enjoyment of it Nonexcludable – hard to prevent people from taking advantage The cleanest example of a public good is defense against a nuclear attack It’s very hard for me to defend myself from a nuclear attack in a way that doesn’t also protect you a bit and you being safe from nuclear attack doesn’t impact my enjoyment of this privilege. Other public goods are urban infrastructure (bridges and roads) (although roads may become somewhat rivalrous when there is congestion); parks, clean air, the ocean, fireworks displays (like on the homework), and so on.

When private goods are owned publicly, they tend to be overutilized/overexploited A principle you may remember from intermediate micro: When private goods are owned publicly, they tend to be overutilized, or overexploited. This is the point of the Hardin paper, the tragedy of the commons His example: a large common area where everyone is permitted to graze their cattle Since it’s public, nobody considers the cost their herd imposes on the grass So the grass on the commons gets wiped out by overgrazing Same problem as overfishing in the communal lake Or overhunting in unregulated public land Another example of this is congestion on busy roads Most roads are provided publicly (no toll, free to use) When there’s lots of traffic, roads become rivalrous – the more people on the road, the less utility I get from driving on them – so they take on one of the characteristics of a private good But when people are deciding whether or not to drive, they tend not to consider the externality that their choice to drive has on other drivers; so the roads get overused (Some cities are looking at ways to solve this problem with congestion pricing – charging people to use the roads during peak hours, so that people internalize this externality.)

When private goods are owned publicly, they tend to be overutilized/overexploited When public goods are privately owned, they tend to be underprovided/undersupplied One the other hand, when public goods are privately owned, they face the opposite problem: they will be underprovided You just saw an example of this: the fireworks problem on the homework Fireworks are a public good; so if each person decides for himself how much to contribute, we get less than the efficient amount of fireworks Another example of this would be artistic creations if they weren’t protected by intellectual property Certainly, something like a song, or a book, is non-rivalrous And technology has made these things much closer to non-excludable If anyone could freely copy my song, or my book, once it’s written, then I might get very little reward for writing it; so I have little incentive to create, and might choose not to Recall our earlier story of a hops farmer and a brewery When there was a single hops farmer, he could negotiate with the brewery to reduce pollution and breathe cleaner air But if the dirty air affects lots of people, it becomes a “public bad” – and if each person tries to negotiate separately with the brewery to reduce pollution, they will reduce it less than efficiency would suggest.

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 These two observations bring us to the following general rule: Efficiency suggests that private goods should be privately owned, and public goods should be publicly provided or regulated Private ownership of private goods avoids overuse, and allows trade, leading to efficient allocations (Coase) Public provision of public goods avoids undersupply This also gives us another interpretation of the Demsetz example we did last week, of the development of property rights to land among Native Americans What makes the case interesting is that land can be either a public or a private good, depending on the circumstances. National forests can be thought of as a public good they’re a good thing ecologically, they’re pretty to drive by and hike in, I can enjoy them even if other people are enjoying them, and it’s hard to exclude other people from getting their benefits. On the other hand, 900 square feet in the middle of a city is a private good if I build an apartment there and live in it, that precludes you doing the same; and as long as I get a door with a decent lock, I can keep you out. Demsetz’s observation was that property rights over land developed among Native Americans as the fur trade became more important economically We can interpret this in terms of public and private goods.

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 Before the fur trade, land was pretty much a public good There was no shortage of animals, so hunting grounds were not particularly rivalrous – I could hunt on your land, and still leave enough game for you to hunt the next day With the emergence of the fur trade came stronger incentives for hunting Fur-bearing animals became more valuable, so were hunted more, so became scarce, so the land became a rivalrous good – the more I hunted, the less luck you would have hunting on the same land So the emergence of the fur trade led to a sort of transition of land from being a public to a private good Efficiency would then suggest that at the same time, it should go from being publicly owned (everyone could hunt on it) to being privately owned (one family might have exclusive rights to hunt in a particular area) Which is pretty much what happened So the general principle is, private goods should be owned privately, and public goods should be publicly provided/regulated The book mentions the move in the 1990s toward deregulation/privitization as an example of correcting a situation of private goods being publicly supplied services that did not involve externalities, and could therefore be supplied by private industry, but for historical reasons were being run by the government in the 1990s, there was a big movement to dismantle or sell off government monopolies on trains, planes, and other services worldwide.

This accords with the principle from Monday
Transaction costs low  facilitate voluntary trade Private goods – low transaction costs Private ownership facilitates trade Transaction costs high  allocate rights efficiently Public goods – high transaction costs Public provision/regulation required to get efficient amount Before the fur trade, land was pretty much a public good There was no shortage of animals, so hunting grounds were not particularly rivalrous – I could hunt on your land, and still leave enough game for you to hunt the next day With the emergence of the fur trade came stronger incentives for hunting Fur-bearing animals became more valuable, so were hunted more, so became scarce, so the land became a rivalrous good – the more I hunted, the less luck you would have hunting on the same land So the emergence of the fur trade led to a sort of transition of land from being a public to a private good Efficiency would then suggest that at the same time, it should go from being publicly owned (everyone could hunt on it) to being privately owned (one family might have exclusive rights to hunt in a particular area) Which is pretty much what happened So the general principle is, private goods should be owned privately, and public goods should be publicly provided/regulated The book mentions the move in the 1990s toward deregulation/privitization as an example of correcting a situation of private goods being publicly supplied services that did not involve externalities, and could therefore be supplied by private industry, but for historical reasons were being run by the government in the 1990s, there was a big movement to dismantle or sell off government monopolies on trains, planes, and other services worldwide.

A different view: transaction costs
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 Cooter and Ulen also point out that in many cases, either type of ownership, public or private, will involve some transaction costs, and the case can be made for one or the other by considering the magnitude of these costs (In fact, we can think of public goods as goods where costs of privately transacting are too high – enforcement costs are high because the good is nonexcludable, or bargaining costs are high because so many people are affected) Consider again the example of clean air If there are lots of consumers affected by pollution from a factory, injunctive relief is unlikely to work well, since transaction costs tend to be high when there are lots of parties affected However, there are still two possible ways to maintain clean air One way is to grant property owners the right to clean air, but protected by damages; so that a factory, if it felt it worthwhile, could choose to pollute and pay damages Alternatively, clean air could be viewed as a public good, and regulated by a government agency We can argue for the efficiency of one system or the other by comparing the magnitude of these transaction costs In the case of damages, the transaction cost here would be the legal cost of these lawsuits, or pretrial negotiations, including the cost to the court of calculating damages In the case of regulation, this would involve the administrative costs of setting up and running a government agency to regulate air quality, and could run the risk of the level of pollution not being the one that is socially optimal Whichever costs would be lower, suggests which system would be more efficient 25 25

How do we design an efficient property law system?
what can be privately owned? what can an owner do? how are property rights established? what remedies are given? We’ve addressed two questions so far. What can be privately owned? (In general, private goods should be privately owned, public goods should be publicly provided or regulated.) What remedies should be given? (In general, injunctive relief when transaction costs are low, damages when transaction costs are high)

What can an owner do with his property?
For efficiency: principle of maximum liberty Owners can do whatever they like with their property… …provided that doesn’t interfere with others’ property or rights That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else Textbook: common law often approximates rule of maximum liberty Does it really? What about bans on repugnant markets? And… This leaves us with the question of, what can an owner do with his property? which we’ve already discussed some in the context of nuisance law Efficiency suggests that anything that makes me better off, and doesn’t affect anyone else, is efficient And so efficiency suggests the principle of maximum liberty maximum liberty suggests that owners can do anything with their property that does not interfere with other peoples’ property or rights that is, you can do anything you like with your property as long as it doesn’t impose an externality on anyone else once one person’s actions begin to affect another, we run into what we’ve already been looking at – nuisance law In the textbook, they make the case that the common law approximates the rule of maximum liberty, although I’m a bit skeptical Legislatures may pass laws that impose further restrictions on what people can do with their property In general, these laws are only efficient if the behavior they are restricting causes an externality.

“Maximum liberty” vs. government’s right to regulate
Ruling two years ago by a Dane County judge Plaintiffs argued they had a “fundamental right to own a cow, and to use their cows in a manner that does not cause harm to a third party” Judge responded: “Plaintiffs do not have a fundamental right to own and use a dairy cow or a dairy herd Plaintiffs do not have a fundamental right to consume the milk from their own cow Plaintiffs do not have a fundamental right to board their cow at the farm of a farmer The private contract does not fall outside the scope of the States’ police power Plaintiffs do not have a fundamental right to produce and consume the foods of their choice DATCP has jurisdiction to regulate the Plaintiffs’ conduct” Here’s an example, though, showing that while “maximum liberty” is a nice theoretical idea, it’s not a legal assumption Plaintiffs owned a couple of cows for their own milk consumption, that they arranged to board at a local farm Asked a judge to clarify that their arrangement was legal August, he ruled against them They requested a clarification, which he issued in September The ruling is discussed here: The discussion in the blog is rather one-sided. There may be a lot more going on here. Might just be saying, can’t own a dairy farm and also segregate a couple cows for “personal use” that are exempt from usual rules. There are likely legitimate reasons (food safety, animal cruelty) to regulate the dairy industry And there may be good reasons to not draw a line between private ownership of a cow or two and running a dairy business But the strength of the language with which the judge “smacked down” the plaintiff does underline the point that “maximum liberty” is not necessarily an accurate description of the world we actually live in (Also: if the judge were applying a new regulation that had just passed after the plaintiffs already owned their cows, this could constitute a regulatory taking – but in this case, he’s applying preexisting regulations that the plaintiffs hoped wouldn’t apply to “private use” cows)

How do we design an efficient property law system?
what can be privately owned? what can an owner do? how are property rights established? what remedies are given? Next, what can an owner do with his/her property?

Fugitive property Hammonds v. Central Kentucky Natural Gas Co.
Central Kentucky leased land lying above natural gas deposits Geological dome lay partly under Hammonds’ land Central Kentucky drilled down and extracted the gas Hammonds sued, claiming some of the gas was his (Anybody see “There Will Be Blood”?) Hammonds Central KY Fugitive property is property that moves around or has indefinite boundaries like foxes or whales Another example: natural gas Hammonds v. Central Kentucky Natural Gas Company (1934) The Central Kentucky Natural Gas Company leased tracts of land above deposits of natural gas But the geological dome of natural gas lay partly under the land they were leasing, and partly under someone else’s land When the company began extracting the gas, Hammonds, one of the other landowners, sued, claiming that some of the gas they were extracting came from under her land. Anybody see the movie “There Will Be Blood”? toward the end, Eli returns to town, wants to lease Daniel Day Lewis the last bit of land in town that he hasn’t yet drilled for oil on Daniel Day Lewis points out the land is worthless – the oil moved around, and he was able to extract all of it through other land he had leased (Then he makes a speech about drinking Eli’s milkshake, and then kills him with a bowling pin.)

Two principles for establishing ownership
First Possession nobody owns fugitive property until someone possesses it first to “capture” a resource owns it Central Kentucky would own all the gas Tied Ownership ownership of fugitive property tied to something else (here, surface) so ownership already determined before resource is extracted Hammonds would own some of the gas, since under his land principle of accession – a new thing is owned by the owner of the proximate or prominent property There are two different principles for how to establish ownership of fugitive property: first possession – fugitive property does not belong to anybody until someone extracts it, establishing ownership tied ownership – ownership of fugitive property is tied to something else which is easier to establish – in this case, the owner of the surface under which the natural gas resides Under first possession, Central Kentucky Natural Gas Company would be entitled to whatever gas it extracted Under tied ownership, they would only be entitled to the gas under their own land, and Hammond’s claim would be valid Tied ownership would also suggest that a landowner has rights to the foxes on his own land. Tied ownership might suggest that if you’re at a baseball game and a foul ball lands on your seat, you have automatic rights to it While first possession suggests that whoever grabs the ball owns it. When tied ownership is used, both the common and civil law often tie ownership using the principle of accession a new thing is owned by the owner of the “proximate or prominent” property, that is, the nearest (or most obvious) thing to link ownership to for example, a newborn calf belongs to the owner of its mother when a river shifts and creates new land, the owner of the river bank owns that new land and the owner of a brand name tends to have the default right to the corresponding Internet address

First Possession versus Tied Ownership
simpler to apply – easy to determine who possessed property first incentive to invest too much to early in order to establish ownership example: $100 of gas, two companies drilling fast or slow drilling slowly costs $5, drilling fast costs $25 drill same speed  each gets half the gas, one drills fast  75/25 Firm 2 First possession has the advantage of generally being very simple (and therefore cheap) to apply Determining who first possessed property is usually straightforward However, first possession also has a downside It creates an incentive to invest too much too early, in order to establish ownership of a scarce resource That is, firms might expend too many resources trying to establish first possession of a resource, leading to inefficiency For example, imagine there is an underground natural gas deposit, and two firms lease land above the deposit This would create a race between them, since the gas was a scarce resource that belonged to whoever possessed it first This would lead to both firms to try to extract it inefficiently quickly, using means that are more expensive than necessary Example: two firms drilling for $100 worth of gas; drilling slow costs $5, fast costs $25; if both do same speed, 50/50 split; if one does fast, 75/25. Game is: slow fast slow 45, ,50 fast 50, ,25 Like prisoner’s dilemma, (fast, fast) is equilibrium, even though (slow,slow) is more efficient So a first possession rule leads to inefficient investment in “possessory acts” – inefficient behavior designed just to claim a valuable resource first Slow Fast 45, 45 20, 50 Slow Firm 1 50, 20 25, 25 Fast

First Possession versus Tied Ownership
simpler to apply – easy to determine who possessed property first incentive to invest too much to early in order to establish ownership Tied Ownership encourages efficient use of the resource but, difficulty of establishing and verifying ownership rights Firm 2 Slow Fast Tied ownership avoids this problem If the ownership of the property to which the rights are tied is already established, tied ownership creates the incentive for efficient use of the resource. If the ownership of the natural gas is not in question, the firm can extract it by the most efficient means possible – there is no need to race to get it first Suppose that due to their rights to the surface, each firm knows that however quickly they extract it, they have rights to have the gas Now there’s no reason not to drill slowly Modify the game, and note the new equilibrium Similarly, if salmon are the property of the owners of the stream where they spawn, the owners have no incentive to deplete the salmon by overfishing. However, as we saw in the Hammonds case, tied ownership faces the difficulty of establishing and verifying ownership rights it is impossible to figure out “which” part of the natural gas being extracted was under Central Kentucky’s land and which part was under Hammond’s 45, 45 45, 25 Slow Firm 1 25, 45 25, 25 Fast

This brings us to the following tradeoff:
Rules that link ownership to possession have the advantage of being easy to administer, and the disadvantage of providing incentives for uneconomic investment in possessory acts. Rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer. This brings us to the following tradeoff: Rules that link ownership to possession have the advantage of being easy to administer and the disadvantage of providing incentives for uneconomic investment in possessory acts. Rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer. So the problem with a first-possession rule is it leads to an investment in possessory acts, which do not create any value, just transfer it The same tradeoff was at work in the fox-hunt case, Pierson v Post Awarding the fox to Pierson, the interloper, links ownership to possession, which is the simpler rule But it gives him an incentive to jump in at the end of the hunt, which is inefficient Awarding the fox to Post, the hunter, allows ownership without possession It avoids the incentive problem, but is more difficult to administer, since there is less of a “bright line” to mark when ownership is established and the claim of ownership is harder to prove Similarly, recall that sperm whales are too fast and strong to hunt with harpoons tied to the ship So if first possession (like fast fish/loose fish) were applied to sperm whales, every time a whale was injured and trailing drogues, you’d have a bunch of ships chasing after it, competing to be the first to secure it – clearly inefficient

We’ve already seen two examples of this
“Fast fish/loose fish” and “the guy who kills a fox, owns it” are examples of a first possession rule You can’t own a resource until you physically possess it “Iron holds the whale” and “the guy chasing a fox owns it” are examples of a tied ownership rule You can establish ownership of something before you actually possess it (A harpoon, or chasing a fox, gives you a right to it) More complicated/costly to enforce “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” But avoids incentive to poach someone else’s resource From decision in Pierson v Post: “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”

Another nice historical example: the Homestead Act of 1862
Meant to encourage settlement of the Western U.S. Citizens could acquire 160 acres of land for free, provided head of a family or 21 years old “for the purpose of actual cultivation, and not… for the use or benefit of someone else” had to live on the claim for 6 months and make “suitable” improvements Basically a first possession rule for land – by living on the land, you gained ownership of it Friedman: caused people to spend inefficiently much to gain ownership of the land A nice historical example of this can be traced to the Homestead Act of 1862 The Homestead Act was meant to encourage people to settle the Western part of the U.S. It allowed citizens to acquire up to 160 acres of public land, provided the claimant was the head of a family or 21 year old the claim was “for the purpose of actual cultivation, and not, either directly or indirectly, for the use or benefit of” someone else the claimant had to live on the claim for 6 months and make “suitable” improvements before title was granted These requirements were meant to prevent a mad rush to acquire land and do nothing with it The Homestead Act was effectively a first possession rule – you could claim the land by living on it We just saw that first possession rules lead to uneconomic investment in possessory acts Friedman points out that the Homestead Act caused people to spend inefficiently much in order to claim land that would later become valuable Quoting from Law’s Order (p 120):

Friedman on the Homestead Act of 1862
“The year is 1862; the piece of land we are considering is… too far from railroads, feed stores, and other people to be cultivated at a profit. …The efficient rule would be to start farming the land the first year that doing so becomes profitable, say But if you set out to homestead the land in 1890, you will get an unpleasant surprise: someone else is already there. …If you want to get the land you will have to come early. By farming it at a loss for a few years you can acquire the right to farm it thereafter at a profit. “The year is 1862; the piece of land we are considering is beyond the margin of settlement, too far from railroads, feed stores, and other people to be cultivated at a profit. As time passes and settlement expands, that situation changes. The efficient rule would be to start farming the land the first year that doing so becomes profitable, say But if you set out to homestead the land in 1890, you will get an unpleasant surprise; someone else is already there. Homesteading land that is already profitable to farm is an attractive proposition, since you not only make money in the process, you also end up with valuable real estate. When valuable rights are being given away for free, there is no shortage of takers. If you want to get the land you will have to come early. By farming it at a loss for a few years you can acquire the right to farm it thereafter at a profit.

Friedman on the Homestead Act of 1862
How early will you have to come? Assume the value of the land in 1890 is going to be $20,000, representing the present value of the profit that can be made by farming it from then on. Further assume that the loss from farming it earlier than that is $1,000 a year. If you try to homestead it in 1880, you again find the land already taken. Someone who homesteads in 1880 pays $10,000 in losses for $20,000 in real estate – not as good as getting it for free, but still an attractive deal. …The land will be claimed about 1870, just early enough so that the losses in the early years balance the later gains. It follows that the effect of the Homestead Act was to wipe out, in costs of premature farming, a large part of the land value of the United States.” How early will you have to come? To make things simple, assume the value of the land in 1890 is going to be $20,000, representing the present value of the profit that can be made by farming it from then on. Further assume that the loss from farming it earlier than that is $1,000 a year. If you try to homestead it in 1880, you again find the land already taken. Someone who homesteads in 1880 pays $10,000 dollars in losses for $20,000 in real estate – not as good as getting it for free, but still an attractive deal. Working through the logic of the argument, we conclude that the land will be claimed about 1870, just early enough so that the losses in the early years balance the later gains. It follows that the effect of the Homestead Act was to wipe out, in costs of premature farming, a large part of the land value of the United States.”

So, what does an efficient property law system look like?
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? (Tradeoff between first possession and tied ownership; more examples to come) What remedies are given? Injunctions when transaction costs are low; damages when transaction costs are high

Sequential Rationality

Dynamic games and sequential rationality
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

Let’s go back to a game we’ve seen – the Battle of the Sexes
Player 2 Ballgame Opera 6, 3 0, 0 Ballgame Player 1 0, 0 3, 6 Opera Now change the game so that player 1 moves first Player 1 goes somewhere Player 2 learns what 1 did, then decides where to go 42 42

Dynamic games are typically shown as “game trees”
PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) A strategy is one player’s plan for what to do at each decision point he/she acts at Player 1: “Ballgame” or “Opera” Player 2’s strategy is more complicated – can depend on P1’s choice

We can expand the matrix to accommodate Player 2’s additional options
Ballgame, Ballgame Ballgame, Opera Opera, Ballgame Opera, Opera 6, 3 6, 3 0, 0 0, 0 Ballgame Player 1 0, 0 3, 6 0, 0 3, 6 Opera Player 2 has four options “Go to the ballgame no matter what” “Go to the ballgame if P1 went to the ballgame, otherwise opera” “Opera if P1 went to the ballgame, otherwise ballgame” “Opera no matter what” 44 44

We can solve this game for equilibrium in the “usual” way
Player 2 Ballgame, Ballgame Ballgame, Opera Opera, Ballgame Opera, Opera 6, 3 6, 3 0, 0 0, 0 Ballgame Player 1 0, 0 3, 6 0, 0 3, 6 Opera Three equilibria: 1 goes to ballgame, 2 plays “ballgame no matter what” 1 goes to ballgame, 2 plays “do what 1 did” 1 goes to opera, 2 plays “opera no matter what” Are all of these “reasonable”? 45 45

Are all these equilibria “reasonable”?
Consider the equilibrium where player 2 plans to go to the opera no matter what player 1 therefore goes to the opera Player 1 might wonder… “Suppose I changed my mind and went to the ballgame. Once I’m there, player 2 has to choose between sticking to the plan, going to the opera, and getting 0… …versus following me to the ballgame and getting 3. If player 2 is rational and I go to the ballgame, she should follow me there, and I’ll end up with a payoff of 6!”

Sequential rationality
Sequential rationality is when a player can count on the other players to behave rationally from that point forward Similar to “dynamic consistency” (macro) When an equilibrium satisfies sequential rationality, we call it a Subgame-Perfect Equilibrium Players play best-responses both in the game as a whole, and in each “subgame,” or part of the game Rules out the opera-opera equilibrium: in the subgame where P1 had already gone to the ballgame, P2 wasn’t playing a best-response In fact, P2 only has one strategy that is sequentially rational: do whatever player 1 did! also called “dynamic consistency” in macro - people make a plan at the beginning, but that plan still seems like the best available option when they reconsider it later, otherwise they wouldn’t stick to it

Subgame Perfect Equilibria are found by Backward Induction
PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) Like with static games, we need to specify the players, the actions, and the payoffs But now, what actions one player chooses among may depend on the action another player took And which action a player chooses can similarly depend on what other players have already done Dynamic games are generally presented via a game tree, where each node of the tree represents a situation where someone has to make a decision Example: suppose there is one firm already operating as a monopolist in some market, and another firm is considering entering If he does enter, than the incumbent firm has two choice: he can play nice, ensuring that both firms end up making money; or he can start a price war, ensuring that both firms end up losing money (If Firm 2 had to choose an action in either case, then his strategies would be more complicated, such as, “Accommodate if Firm 1 enters, and do X if Firm 1 does not enter”) Start at the “bottom,” solve for what P2 would do at each point If P2 is rational and P1 knows it, P1 can infer what payoff he would get from each move Now figure out what P1 would do, given those payoffs

Subgame Perfect Equilibria are found by Backward Induction
PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) Like with static games, we need to specify the players, the actions, and the payoffs But now, what actions one player chooses among may depend on the action another player took And which action a player chooses can similarly depend on what other players have already done Dynamic games are generally presented via a game tree, where each node of the tree represents a situation where someone has to make a decision Example: suppose there is one firm already operating as a monopolist in some market, and another firm is considering entering If he does enter, than the incumbent firm has two choice: he can play nice, ensuring that both firms end up making money; or he can start a price war, ensuring that both firms end up losing money (If Firm 2 had to choose an action in either case, then his strategies would be more complicated, such as, “Accommodate if Firm 1 enters, and do X if Firm 1 does not enter”) This game has a unique subgame-perfect equilibrium Player 1 plays Ballgame Player 2 plays Ballgame if 1 plays Ballgame, Opera if 1 plays Opera “Most” dynamic games have just one SPE

Moving first can be good or bad, depending on the game
Battle of the sexes: moving first is good You know your partner will accommodate whatever you do… …so you get your first choice Some games: being able to “commit” to a decision, while your opponent still has to decide, can be good! (Another example: entry game) Scissors-paper-rock: moving first is terrible You always lose Some games: reacting to your opponent’s move is good!

When we look at dynamic games, we’ll always look only at subgame-perfect equilibrium
Key assumption: common knowledge of rationality Player 1 knows player 2 is rational… …so whatever he does, she’ll do what’s best for her… …so player 1 can confidently go to the ballgame This is the key to sequential rationality The assumption that, whatever happens first, players will continue to act rationally in their own best interest Which means we can “solve the game” from the end, and figure out the beginning players’ optimal moves (Backward induction has been used to solve checkers – it’s a draw – and will eventually solve chess…) The key assumption here is common knowledge of rationality The players know each others’ payoff functions, everyone is rational, everyone knows everyone is rational, everyone knows everyone knows everyone is rational, and so on If you’re playing a game like this against someone who’s crazy, it’s hard to know what would happen And in fact, a “crazy” player – someone who doesn’t always do what’s best for them – might do better than a “rational” player Because if I’m crazy and I’m firm 2, you might believe that I’ll actually fight if you enter; so you might choose not to enter But if you know I’m rational, then you’re better off entering, since you know that once you enter, I won’t want to fight (Literature on repeated games with reputation, where your actions in the early stages may partly be to try to convince opponents that you’re not a rational player, and therefore that they shouldn’t try to take advantage of you in later stages.) But for us, we’ll stick to the assumption of rationality – I know that if I move first, my opponent will do whatever is in his best interest This is referred to as sequential rationality – since the players are assumed to be rational at each stage of the game

Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 7.

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Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 7.

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