1. Econ 522 Economics of Law
Dan Quint
Spring 2013
Lecture 6

2. Our story so far on property law…
Coase: absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation
So we can always get efficient outcomes “automatically”…
…provided there are no transaction costs
But what to do when there are?

3. Different types/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

4. Two normative approaches to the law
Normative Coase: aim to minimize transaction costs
Normative Hobbes: aim to allocate rights efficiently (or minimize the need for bargaining/trade)
How to choose between the two?
When transaction costs are low and information costs high, design law to minimize transaction costs
What transaction costs are high and information costs are low, design law to allocate rights efficiently

5. Two normative approaches to the law
Defaulting to the normative Coase approach means relying on bargaining to reallocate rights efficiently
Is it realistic to think this will work in real life?
Is it realistic to think this would work in a room full of undergrad econ majors?

6. An experiment on “Coasian bargaining”

7. Experiment: Coasian bargaining
Round 1 (full information)
Ten people, five of them have a poker chip to start
Each person is given a personal value for a poker chip
At the end of the round, that’s how much you can trade in a chip for
Purple chip is worth that number, red chip is worth 2 x your number
So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it
Each person can only sell back one chip
Your number is on your nametag (common knowledge)

8. Experiment: Coasian bargaining
Round 2 (private information)
Ten people, five of them have a poker chip to start
Each person is given a personal value for a poker chip
At the end of the round, that’s how much you can trade in a chip for
Purple chip is worth that number, red chip is worth 2 x your number
So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it
Each person can only sell back one chip
Only you know your number

9. Experiment: Coasian bargaining
Round 3 (uncertainty)
Six people, three poker chips
Value of each chip is determined by a die roll
If seller keeps the chip, it’s worth 2 x roll of the die
If new buyer buys chip, it’s worth 3 x roll of the die
No contingent trades – buyer must pay cash
Nobody sees the die roll until the end

10. Experiment: Coasian bargaining
Round 4 (asymmetric information)
Six people, three poker chips
Value of each chip is determined by a die roll
If seller keeps the chip, it’s worth 2 x roll of the die
If new buyer buys chip, it’s worth 3 x roll of the die
No contingent trades – buyer must pay cash
Seller sees the die roll initially, buyer does not

11. Back to work

12. Last week: what things should be privately owned?
Public Goods
non-rivalrous, non-excludable
tend to be underprovided when privately supplied
tend to have high transaction costs (many people involved)
suggests public provision/regulation preferable
Private goods
rivalrous, excludable
tend to be overexploited when publicly owned
tend to have low transaction costs (one buyer, one seller)
suggests private ownership preferable

13. 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

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

15. 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 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?

16. 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

17. 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

18. 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

19. 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.

20. 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

21. 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.

22. 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

23. 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.)

24. 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

25. 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

26. Exactly agrees with our earlier principle
Transactions costs low: design law to facilitate trade
Property rule does this: clarifies right, allows trade
Transaction costs high: design law to minimize losses due to failures of private bargaining
Liability rule does this: gives injurer right to violate entitlement when efficient, even without prior consent
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

27. 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:

28. 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.

29. 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). 

30. So, do we buy it?
Coase relies on parties being able to negotiate privately if the right is not assigned efficiently
Low-TC case: injunctions more efficient, assuming bargaining works if “wrong” party is awarded the right
But does it work?
Paper by Farnsworth shows no bargaining after 20 nuisance cases
Our experiment showed various transaction costs that could be a problem: private information, uncertainty, asymmetric information
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

31. 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

32. 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

33. 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/

34. 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?

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

36. 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?

37. 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.)

38. 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

39. 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

40. 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

41. 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

42. A 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):

43. 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.

44. 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.”

45. 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