1. Econ351 Lecture 7. Coase Theorem and property rights

2. Lecture outline Different ways of handling externalities Coase Theorem
Transaction costs of negotiations
Components of transaction costs
Factors that affect transaction costs
Some implications of Coase Theorem and Hobbes Theorem for property law

3. Example of externalities
A chemical plant (CP) is located near a river and a fishery (F) is located downstream from the plant. CP pollutes the river and the amount of pollution depends on the amount of output it produces. CP can produce from 0 to 4 units of output, with each unit of output resulting in one “unit of pollution.” CP’s profit and the damages incurred by F depend on the amount of output and are given in the table below:

4. Example of externalities (cont.)
Output of CP
MB of CP
Total CP benefit
MC of F
Net Social benefit -- 1
10,000
5,000 ? 2
6,000
16,000 3
4,000
20,000 4
2,500
22,500

5. Example of externalities (cont.)
What would be the output of profit-maximizing CP given these conditions and no other constraints on CP?
What is the socially optimal output of CP?

6. Example of externalities (cont.)
How would your answers change if: (1) the plant can install a filter that eliminates pollution at the cost of $3000/unit of pollution? (2) the fishery can install a filter that eliminates all pollution at the cost of $11,500?

7. Handling externalities before Coase
How can socially efficient outcome be achieved (pre-Coase views)?
Regulation
Taxation
Fishery can sue for damages

8. Handling externalities before Coase
Regulation: CP is told to produce certain amount of output
Disadvantages of regulation (goals of regulators; informational requirements)
Pigouvian (effluent) taxes: CP’s output is taxed
Disadvantages of Pigouvian taxes (goals of tax-setter; informational requirements)
Suing for damages (how is it different from taxation?)
Without full information no approach works well

9. Coase’s insights
First: Externalities are reciprocal (no party causes externality by itself)
Second: parties can negotiate around externalities and as long as it’s possible to negotiate and enforce contracts between them at low cost, neither regulation nor Pigouvian taxes are necessary

10. Coase Theorem
If the transaction costs are zero (i.e., if any mutually beneficial agreement is made) then any initial allocation of property rights leads to socially efficient outcome
Notes:
This is a tautology
Transaction costs are never zero
While all outcomes are efficient, they are not necessarily the same for all initial allocations
Endowment effect

11. Example of externalities (copy)
Output of CP
MB of CP
Total CP benefit
MC of F
Net Social benefit -- 1
10,000
5,000 ? 2
6,000
16,000 3
4,000
20,000 4
2,500
22,500

12. Coase Theorem and the externalities example
What would be the outcomes of negotiations in the earlier example of externalities (CP v. F) assuming zero TC under the following allocation of property rights?
CP has the right to pollute
CP has the right to pollute and can install a filter eliminating pollution at $3000/unit
F has the right to clean water
F has the right to clean water and can install a filter eliminating all pollution at $11,500

13. Calculation of payments
CP has the right to pollute and no filtering is possible. How do we calculate payments that would result from Nash bargaining?
Step 1: Determine threat points
CP: F:
Step 2: Determine cooperative joint wealth
CP (16000) + F (-10000) = 6000
Step 3: Determine surplus
S = (16000 – 10000) – ( ) = 3500
Add half of surplus to each threat point to arrive at cooperative allocation of wealth for each agent
CP: = F: =-18250
Determine payments implied by the above
CP gets paid – = 8250

14. Continuous values version of the externalities example
Look at Externalities (calculus-based) link at

15. Another example
Sturges(Doctor, plaintiff) v. Bridgman (Confectioner, defendant), A confectioner (C) used two mortars and pestles to pound mixtures used in his business. A doctor (D) came to occupy neighboring premises and built a room for seeing patients next to C’s kitchen. The noise from C’s business made it difficult for D to listen to the patients for diseases in the chest. So, D sued.

16. Sturges v. Bridgman example
Reciprocity?
Let C value his business at 40 and D value his at 60. Alternatives are worth 0 and let TC=0
Rule 1: C has the right
Rule 2: D has the right
Rule 1 and C can install soundproofing for $20
Rule 2 and D can move for $18
(see class handout for an example of Nash bargaining solution for Rule 1)

17. Sturges v. Bridgman example (cont.)
Let TC= 25
Rule 1: C has the right
Rule 2: D has the right
2d part of Coase Theorem: If the transaction costs of negotiations are high then the efficiency of outcomes may depend on the initial allocation of property rights

18. Transaction costs of negotiations
Search costs
Bargaining costs
Enforcement costs
First two categories include private information
Factors affecting transaction costs (see class handout)

19. Implications of the Coase Theorem for the structure of the law
Coase: the law should be structured to reduce impediments to private agreements (i.e., “lubricate bargaining”) – “Normative Coase theorem”
Hobbes’ alternative: Structure the law so as to minimize the harm caused by failures in private agreements (i.e., give the right to the party that values it most)
Why not always use Hobbes’ prescription?
Hobbes (in Leviathan): "war of all against all“ and in the “state of nature” (i.e., w/o civil society, government) there would be “continual fear, and danger of violent death; and the life of man, solitary, poor, nasty, brutish, and short.”

20. Coase v. Hobbes
When does it make sense to follow Coase’s prescription and when Hobbes’ prescription?
IC < TC (and surplus > IC)  Hobbes*
IC > TC  follow simple rules (precedent, coming to a nuisance, etc.) to decide property disputes
* - IC stands for “information costs” or costs for the court to obtain appropriate information

21. Protection of property rights
Terminology
legal remedies (damages; liability rule)
Equitable remedies (injunction; property rule)
Damages:
Compensate plaintiff
Backward-looking
Injunction: forward-looking
What happens if defendant doesn’t comply?

22. Back to CP v. F example F’s right is protected by injunction
TC = 0
TC >> 0
F’s right is protected by damages

23. Difficulties with using injunctions
Intermediate injunction: too much information is needed
Absolute injunction: often relies on low transaction costs, including those generated by:
Free rider problem
Hold-up problem

24. Free rider problem
Suppose in the example with CP and F there are 100 fishermen instead of a fishery
Free-rider problem: Let CP have the right to pollute. Then each fisherman can pay CP between $65 and $100 to limit its output to 2 units. Notice that if 90 fishermen agree to pay $80>$6500/90, then the remaining fishermen can pay nothing and benefit from the socially efficient amount of pollution.

25. Hold-up problem
Let the fishermen have the right to clean water. Then CP could offer between $100 and $160 to each fisherman for the right to produce 2 units of output. Let the offer be $130. Then, one of the fishermen could hold out for a much greater amount (up to ( *99) = $3130. Suppose he holds out for $1200. If there are more such smart fishermen, this can derail the negotiations.

26. Difficulties with using damages
Calculating damages requires resources
If damages are set incorrectly, negotiations might be necessary to achieve efficiency and that brings us back to the issue of transaction costs of negotiations
With any remedy, predictability is important for the economy to function well

27. Summary on remedies
Zero transaction costs - legal rule does not matter, except for distribution
High transaction costs of negotiations, court has perfect information (including knowledge of all potential remedial or preventive actions) - efficiency could be achieved either under appropriate choice of injunction or under compensatory damages

28. Summary on remedies (cont.)
High transaction costs, profit schedule unknown, damages known - damages may be efficient or may be not, because plaintiff has no incentive to use prevention;
High transaction costs, profit schedule unknown, damages are unknown - efficiency is not achieved in a general case.

29. Practice questions
Q. 1. Use the theory of transaction costs to explain whether (from the efficiency point of view) the following rights should be protected by injunction or damages:
a land owner's right to exclude from his property a neighbor's gas line;
a homeowner's right to be free from air pollution by a nearby factory.

30. Practice questions (cont.)
Q. 2. Suppose that two people choose to litigate a dispute. Should the law presume that if two parties are prepared to litigate, transaction costs must be high, and therefore the court should choose damages as the remedy, not the injunction?

31. Practice questions (cont.)
Q. 3. (a) under English common law, a landowner who built a structure that so blocked his neighbor's window, that the neighbor needed artificial light to be able to read in ½ of the room nearest the window, was considered to have infringed the neighbor's property rights, provided that the neighbor had unobstructed access to light for 20 years. Explain from the point of view of efficiency. (b) the courts did not extend this rule to protect distant views. Why? (c) this common law rule was rejected in the US. Why?

32. Practice questions (cont.)
Q4. Why is smoking in public places heavily regulated and often even prohibited, while it is generally left up to the individuals in private residences?

33. So far we have looked at:
The reasons for the existence of property rights
(Partly) The issue of what owners may do with their property (externalities)
The role of bargaining
The efficiency characteristics of the remedies for violating property rights? (injunction vs. damages)

34. What should be privately owned?
Should property always be private?
Public goods:
Non-rivalrous
Non-exclusionary (or non-excludable)
Example: country’s defense
Most public goods are not pure public goods (roads, information)

35. Example
Highway: excludable, but at a cost; non-rivalrous, but only up to a point
Assume a road costs $1 mln. to build and maintain. Let the combined benefit from it to all people be $1.2 mln. Such a road is beneficial to society.
Suppose it is privately owned. Additional costs? Benefits?
Tolls, lower consumer surplus
More efficient maintenance

36. Another view of private ownership benefits
Private ownership can work under contract with government (if gov-t is not too corrupt)
Eliminates the need for tolls on a road;
Leaves only non-contractible quality problems to take care of
Competition and reputation can be used to discipline private contractors
Preserves efficiency of private ownership
(See, Shleifer’s “State vs. Private Ownership” at

37. Efficiency vs. distributional justice
How can legal rules work to make distribution more equal?
Unintended consequences of legal rules (recall non-waivable warranty of habitability)
Predictability of the law (e.g., consider Sturges v. Bridgman)
Availability of better tools for redistribution (progressive taxation, social benefits)