1. Econ 522 Economics of Law
Dan Quint
Fall 2010
Lecture 5

2. Monday…
Coase Theorem: in the absence of transaction costs, if property rights are well-defined and tradable, we’ll always get efficiency
Or: if property rights are complete enough, we can overcome externalities
Or, if conditions are perfect, initial allocation of rights doesn’t matter (for efficiency)
But if there are transaction costs, this breaks down
Today:
Demsetz – when will property rights expand?
Transaction costs

3. Demsetz

4. We motivated property law by looking at a game between two neighboring farmers
ORIGINAL GAME
MODIFIED GAME
Player 2
Player 2
Farm
Steal
Farm
Steal
10, 10
-5, 12
10 – c, 10 – c
-5 – c, 12 – P
Farm
Farm
Player 1
Player 1
12, -5
0, 0
12 – P, -5 – c
-P, -P
Note that when I steal from you, this is just an externality – my action reduces your payoff.
Changing the game led to me at least partly internalizing this externality.
Steal
Steal
Changing the game had two effects:
Allowed us to cooperate by not stealing from each other
Introduced a cost c of administering a property rights system 3 3

5. Harold Demsetz (1967), “Toward a Theory of Property Rights”
“A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities”
“[ In order for an externality to persist, ] The cost of a transaction in the rights between the parties… must exceed the gains from internalization.”
“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”
Harold Demsetz, in “Toward a Theory of Property Rights” (on the syllabus).
Demsetz points out, “A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities.”
Think about the fishing example: each fisherman imposed a negative externality on all the others, leading to an inefficient outcome
We could solve the problem if we could solve the externality
For example, divide up the lake in 20 parts, and build underwater fences between the different parts, so fish wouldn’t move back and forth
This way, we each have a specific area we’re allowed to fish
Now there’s no externality, and we would each fish the efficient amount within our segment of the lake
But bickering over who gets which part of the lake, and building the underwater fences, might be very costly
And Demsetz points out, the externality will remain as long as the cost of fixing it is greater than the benefit
That is, in order for an externality to persist, “The cost of a transaction in the rights between the parties… must exceed the gains from internalization.”
We can always solve the externality problem by introducing a transaction, or a new market, but this will also come at some cost
A more extensive property right system is more complicated, and more costly to implement
Think about iron-holds-the-whale – more complete property rights (someone owns a whale once there’s a harpoon in it), but more costly to implement (more disputes)
Demsetz then makes the case that property rights will naturally evolve to be more complete as the benefit outweighs the cost
that is, as the value of overcoming a particular externality grows, relative to the costs of implementing more complete (and complex) property rights.
In his words, “Property rights develop to internalize externalities when the gains of internalization become larger than the cost of internalization.”

6. Harold Demsetz (1967), “Toward a Theory of Property Rights”
“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”
Private ownership of land among Native Americans
Cost of administering private ownership: medium
Before fur trade…
externality was small, so gains from internalization were small
gains < costs  no private ownership of land
To repeat that: “Property rights develop to internalize externalities when the gains of internalization become larger than the cost of internalization.”
That is, if the gains from fixing the problem – the increase in efficiency that Coasian bargaining allows – gets to be bigger than the cost of administering the system, property rights will naturally evolve to be more complete, to fix that externality
He gives the example of land ownership among Native Americans
Specifically, he points out that a close relationship exists between the development of private land rights and the development of the commercial fur trade.
When land is not privately owned, nobody has an incentive to increase or maintain the stock of animals on the land, or to limit their hunting
Each hunter considers his private benefit from killing an animal, versus the private cost (his effort, plus the slightly lower availability of animals in the future)
But ignores the externality he has on other hunters
So overhunting will tend to occur
This is the classic “tragedy of the commons” described in the Hardin paper, and that we saw with the fishing example – resources that are free to everyone, tend to be overused
Before the fur trade became established in North America, hunting was done primarily for food
the externality that one hunter imposed on other hunters, by lowering the amount of game available, was present, but was a fairly small problem
And historians have established that at that time, Native Americans did not have anything resembling private ownership of land.

7. Harold Demsetz (1967), “Toward a Theory of Property Rights”
“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”
Private ownership of land among Native Americans
Cost of administering private ownership: medium
Before fur trade…
externality was small, so gains from internalization were small
gains < costs  no private ownership of land
As fur trading developed…
externality grew, so gains from internalization grew
gains > costs  private property rights developed
As the fur trade began by the early 1700s, furs became more valuable, since they could be traded for other goods that were not plentiful
So the scale of hunting increased
So overhunting became more of a problem, and the size of the externality that hunters imposed on each other increased
And at exactly that time, in the areas where the fur trade was most important, Native Americans began to recognize exclusive family rights to hunt and trap in particular areas.
(Neat quote: “a starving Indian could kill and eat another’s beaver if he left the fur and the tail.”)
Property rights weren’t absolute
You could still cross other peoples’ land
And if you were on someone else’s land, and you were hungry, you could still hunt to eat
But you had to prove that you were only hunting for food, not for profit – by leaving the commercially valuable parts of the animal
Demsetz points out that at that same time, in the southwestern plains, there were no animals of the same commercial significance, and the animals that were there tended to roam over a larger area; and in the southwest, similar private property rights did not emerge
In addition, in the areas where private rights to land were emerging, careful steps were taken by the “owners” of the land to avoid overhunting – such as rotating among different hunting areas year by year, and maintaining one area in which no hunting was done.
So just like we’d expect – more complete property rights led to more efficient use of the resource, because they solved an externality problem
And property rights developed naturally as the value of solving the externality grew (due to outside forces)

8. Friedman tells a similar story: “we owe civilization to the dogs”
The date is 10,000 or 11,000 B.C. You are a member of a primitive tribe that farms its land in common. Farming land in common is a pain; you spend almost as much time watching each other and arguing about who is or is not doing his share as you do scratching the ground with pointed sticks and pulling weeds.
…It has occurred to several of you that the problem would disappear if you converted the common land to private property. Each person would farm his own land; if your neighbor chose not to work very hard, it would be he and his children, not you and yours, that would go hungry.

9. Friedman tells a similar story: “we owe civilization to the dogs”
There is a problem with this solution… Private property does not enforce itself. Someone has to make sure that the lazy neighbor doesn’t solve his food shortage at your expense.
[Now] you will have to spend your nights making sure they are not working hard harvesting your fields. All things considered, you conclude that communal farming is the least bad solution.

10. Friedman tells a similar story: “we owe civilization to the dogs”
Agricultural land continues to be treated as a commons for another thousand years, until somebody makes a radical technological innovation: the domestication of the dog.
Dogs, being territorial animals, can be taught to identify their owner’s property as their territory and respond appropriately to trespassers. Now you can convert to private property in agricultural land and sleep soundly. Think of it as the bionic burglar alarm.
-Friedman, Law’s Order, p. 118
Friedman is making the exact same point as Demsetz did:
Before dogs, there was a clear gain to privatizing agricultural land, but the cost was too great
When dogs were domesticated, the cost fell, so that now it made sense to move from communal farming to private property

11. So…
Coase: if property rights are complete and tradable, we’ll always get efficiency
or, we can eliminate externalities by introducing trade in missing markets – that is, by making property rights more complete
Demsetz:
yes, but this comes at a cost
property rights will expand when the benefits outweigh the costs
either because the benefits rise…
…or because the costs fall
The costs Demsetz was talking about are straightforward…
…but let’s go back to the transaction costs of Coase
So there you have it
Coase says, if property rights are complete and tradeable, we’ll always get efficiency
Or in other words, we can solve any externality by expanding property rights to cover it
Demsetz says yes, but this comes at a cost – more extensive property rights cost more to implement
So property rights will expand when the benefits outweigh these costs
This can happen either because the benefits go up, or the costs go down
In the example we just gave from Demsetz, the benefits went up – overhunting became more of a problem, so the gains from having property rights increased
On the other hand, the invention of barbed wire probably reduced the cost of maintaining property rights – by making it easier to keep people off your property

12. Transaction Costs

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

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

15. Bargaining costs come in many forms
Asymmetric information
Akerloff (1970), “The Market for Lemons” – adverse selection
Private information (don’t know each others’ threat points)
Myerson and Satterthwaite (1983), “Efficient Mechanisms for Bilateral Trading” – always some chance of inefficiency
Next, even if we agree on the physical condition of the car, you might not be sure exactly how badly I want it
Suppose we both know the car is worth $3000 to you, but you don’t know what it’s worth to me – all you know is, I value it somewhere between $3000 and $5000
And suppose it turns out, I value it at $3200
Since I value it at more than $3000, there are gains from trade – it’s definitely efficient for you to sell me the car
But now I try to convince you that the car’s only worth $3200 to me, and that you should therefore sell it to you for $3100
But here’s the problem: anything that I say to try to convince you, I could also say if the car was actually worth $5000 to me
And you have no way of knowing whether I’m telling the truth or just haggling to get a better price
So if you give in and sell me the car for less than $3200, you can’t escape the possibility that you’d also give me that price if I valued it at $5000
So you say, “Maybe you’re telling the truth, and maybe you’re lying, but I won’t sell it for less than $4000.”
Which means that some of the time, even though I value the car more than you, we don’t reach a deal
There’s a famous paper by Roger Myerson and Mark Satterthwaite, “Efficient Mechanisms for Bilateral Trade,” which shows that when there’s private information of this sort, there is no way to guarantee that the efficient outcome will always be reached – there’s always some probability that an inefficient outcome (in this case, no trade) occurs
So a second source of bargaining costs: not knowing each others’ threat points

16. Bargaining costs come in many forms
Asymmetric information
Akerloff (1970), “The Market for Lemons” – adverse selection
Private information (don’t know each others’ threat points)
Myerson and Satterthwaite (1983), “Efficient Mechanisms for Bilateral Trading” – always some chance of inefficiency
Uncertainty
If property rights are ambiguous, threat points are uncertain, and bargaining is difficult
There have been a number of papers on bargaining, both theoretical and experimental, that reinforce the fact that bargaining is more likely to fail if parties don’t know each others’ threat points
One interpretation of threat points being private information is simply that tastes are subjective – you don’t know how much I like the color of the car, for instance
But another source of uncertainty about threat points is when property rights themselves are ambiguous
Consider again the problem of the rancher and the farmer, and suppose that the efficient outcome is for the farmer to build a fence to protect his crops
But now suppose that the law is ambiguous – whether or not the rancher is liable for his crop’s damage is open to interpretation, or depends on the exact details of the situation, so the court’s decision is unpredictable
In that case, the rancher and the farmer might not agree on what would happen if no fence was built; and so each one might be uncertain about the other one’s threat point, and therefore it might be very hard for them to come to an agreement
This is one of the arguments for clear, simple, well-defined, unambiguous property rights – that they make negotiations easier, that is, effectively lowering transaction costs.

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

18. Bargaining costs come in many forms
Large numbers of parties
Developer values large area of land at $1,000,000
10 homeowners, each value their plot at $80,000
Holdout, freeriding
Hostility
And the same thing can happen when there are many buyers instead of many sellers
Suppose that instead of a shopping mall, the land was being bought up to be turned into a park, that would benefit 10,000 people in the community, and each of them would receive benefits worth $100 from the joy of having the park
Even if the homeowners were all willing to sell for $80,000, or $800,000 total, it might be impossible to raise that much through voluntary contributions, since each citizen might think, “We only need to raise $800,000, and all my neighbors should be willing to pay $100, so even if I don’t pay anything, the park should get built!”
This is the problem of freeriders – once the park is built, its use won’t be limited to the people who paid for it, so people may try to avoid paying, preferring to get the benefits for free.
So when negotiations need to take place between lots of people, rather than just one buyer and one seller, there is a risk of holdout – individual sellers holding out for high prices – and freeriding – individual buyers trying to get the good for free
Either of these could cause negotiations to fail, or to take a long time to conclude
And even if negotiations go smoothly, it’s costly to negotiate with lots of individuals
Arthur Pigou, on railroads and sparks
So another source of bargaining costs is having lots of individuals to negotiate with
One final source of bargaining costs is hostility
I’ll come back to this next week
Many divorce agreements end up being settled by litigation, which is more costly than negotiation, not because the parties disagree about their threat points or for any other rational reason, but because the parties are angry with each other and don’t want to come to a rational agreement

19. 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

20. So, what do we do?

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

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

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

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

25. Designing an efficient property law system

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

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

28. 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
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

29. 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
Liability rule / damages
Damages are a payment to a victim to compensate for actual damage done
Better when prior negotiation is impossible
Inalienability
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

30. 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

31. 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.

32. 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

33. 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.

34. 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

35. How do we choose between the rules?
In this case…
Polluter’s rights > damages > injunction when there is no bargaining
All three equally efficient when there is bargaining
Normative Hobbes: allocate rights efficiently to begin with
Polluter’s rights in this case, no reason to believe this more generally
Normative Coase: just work to lower transaction costs, let people negotiate when they need to
So what do we do?
Remember our two normative approaches from last class

36. How do we choose between the rules?
Injunctions are cheaper for court to implement
No need to calculate exact amount of damage done
Damages are more efficient when private bargaining fails
Leads Calabresi and Melamed to the following conclusion:
When transaction costs are high, a liability rule (damages) is more efficient
When transaction costs are low, a property rule (injunctive relief) 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 high (or there are impediments to private negotiations), a liability rule (damages) is more efficient
When transaction costs are low (or private negotiations can be expected to succeed), a property rule (or injunctive relief) is more efficient

37. So that’s our answer: Calabresi and Melamed
When transaction costs are high, a liability rule (damages) is more efficient
When transaction costs are low, a property rule (injunctive relief) is more efficient
Why are damages more efficient when bargaining fails?
Under damages rule, injurer has two choices: prevent the damage, or pay cost afterwards
Under injunction, injurer has only one choice: prevent the damage
Injuree is compensated, so doesn’t matter to him
So whichever is cheaper for injurer, is more efficient
So that’s our answer.
When transaction costs are high, bargaining is likely to fail, and a liability rule is more efficient
When transaction costs are low, injunctive relief is more efficient, since the parties can reallocate the right if it’s assigned incorrectly
Why is liability more efficient when bargaining is likely to fail?
Think of it this way
In the example we just saw, there were three ways to deal with the harm: the electric company could prevent it, the laundry could prevent it, or they could both just let it happen and deal with it
When the two parties bargain, they’ll always choose whichever of the three is cheapest – so they’ll get the efficient outcome
When the two parties don’t bargain, under an injunction, the electric company has only one choice: prevent the harm itself
Under a damages rule, it has two choices: prevent the harm itself, or allow the harm to occur and pay damages
The laundromat doesn’t care which he does – the laundromat will be fully reimbursed for any harm that does occur
So the electric company faces the full cost in either case; it will choose the cheaper option, and therefore the more efficient option
When the electric company can prevent the harm at a lower cost than the cost of the harm itself, injunctions or damages will lead to the same outcome
When it can not, injunctions will be more costly than damages

38. 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 this is how things are typically done in certain types of disputes
“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:

39. 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.

40. 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). 

41. Third remedy: inalienability
Inalienability: when an entitlement is not transferable or saleable
As the title of the paper suggests, Calabresi and Melamed also talk about a third type of protection for entitlements: inalienability
This is when an entitlement is not transferable or sellable
For example, I an entitled to not be a slave, and I am not allowed to give away or sell that right
Similarly, you can’t give away or sell your right to vote
(We can think of this as the case of owning a historical landmark: it is your property, but it may be unalienable, in that you cannot sell it to someone who would put it to a different use.)
Inalienability is a bit of a funny case
The word might resonate as being a positive one – think of the well-known line from the Declaration of Independence, that all men are endowed with “certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness”
But in our context, inalienability seems more negative
Everything we’ve done so far – in particular, Coase – has assumed that the way to get efficient outcomes it to allow people to trade rights with each other, in order to get them owned by whoever values them the most
I own two kidneys; some kidney patient needs one; if my second kidney is worth more to him than to me, why shouldn’t I be allowed to sell it to him?
In some cases, we can defend inalienability by talking about externalities
If giving away a particular right imposed a large externality on others, maybe it makes sense not to allow it
In other cases, it seems to be more a case of paternalism
that is, the government thinking it knows what is good for you
In the kidney case, it may have nothing to do with the kidney itself, but the incentives for other behavior
we might acknowledge that me having two kidneys is inefficient; but if we allowed the sale and trade of kidneys, then murder rates might go up, because everyone was always carrying around hundreds of thousands of dollars worth of organs
But inalienability is not that common – thinking about remedies usually comes down to comparing injunctive relief to damages

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