Econ 522 Economics of Law Dan Quint Spring 2013 Lecture 5.

Econ 522 Economics of Law Dan Quint Spring 2013 Lecture 5

Reminder HW1 due online at 11:59 p.m. Thursday

Monday, we saw the Coase Theorem
Coase Theorem: In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency. The initial allocation of property rights therefore does not matter for achieving efficiency… …provided there are no transaction costs On the other hand, the initial allocation does affect distribution… And if there are transaction costs, it can also affect efficiency So that’s the Coase Theorem Of course, the limitations we mentioned still hold: First, Coase says that the initial allocation of rights (or liability) does not matter for efficiency – but as we said, it does matter for distribution And second, all of this only works in the absence of any transaction costs – which may not be the case in the real world (we’ll come back to transaction costs in a bit)

At the end, we related this to General Equilibrium and the First Welfare Theorem
GE: consumers and firms take prices as given, optimize consumption/production; prices are such that markets clear First Welfare Theorem: general equilibrium is efficient Breaks down when there are externalities, or “missing markets” Something in peoples’ utility functions that they can’t demand So one way to fix externalities is to “make markets more complete” Same as Coase – once we allow trade in something, it should get allocated efficiently

Many externalities can be thought of as missing property rights
Overfishing in communal lake? It’s because property rights over those fish aren’t well-defined Firm polluting too much? It’s because property rights over clean air aren’t well-defined So one solution… Make property rights complete enough to cover “everything,” and tradable, and use the law to minimize transaction costs… …Then Coase kicks in and we get efficiency! (Booya!) So why not do this? COSTS!

Today When will it be worth it to expand property rights to correct an externality problem? What do we do when there are transaction costs, so efficiency is not guaranteed?

When are stronger property rights “worth it”?

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 7 7

Private property leads to better use of resources, by eliminating externalities
Incentive to overuse communal resources “Tragedy of the commons” – private property rights can fix this Collective farming – incentive to shirk/freeride Again, private property rights fix this – for example… “It’s one of the ironies of American history that when the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death. Fortunately… Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced. Bradford described the results… “[Ending corn collectivism] had very good success, for it made all hands very industrious… The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability…”” - Marginal Revolution (blog post), “Thanksgiving Lessons” Source:

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), summarizes Coase this way: in a world without transaction costs, “The output mix that results when the exchange of property rights is allowed is efficient and the mix is independent of who is assigned ownership (except that different wealth distributions may result in different demands).” Elsewhere, he points out, “A primary function of property rights is that of guiding incentives to achieve a greater internalization of externalities.” Again, stick with the “farmer’s rights” world, where the farmer could build a fence for $200, or the rancher could for $400 If I’m the farmer, then my not building the fence imposes an externality of $400 on the rancher – it forces him to spend $400 on a fence But with property rights, this costs me $400 in opportunity cost – since instead, I could get him to pay me $400 and build the fence So now not building the fence costs me $400 – exactly the same as the externality it causes So the “smoothly functioning price system” causes me to internalize the externality and do what’s efficient. Thus, in order for an externality to persist, Demsetz argues, “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 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.”

“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: moderate 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 – 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.

“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: moderate 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, 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)

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.

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.

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

So… Coase: if property rights are complete and tradable, we’ll always get efficiency can “fix” externalities by expanding property rights to cover 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 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 Of course, Coase wasn’t completely ignoring costs – it’s just that the strongest form of the Coase result is for the case where there are no transaction costs

Of course, Coase wasn’t actually ignoring costs…
“If market transactions were costless, all that matters (questions of equity apart) is that the rights of the various parties should be well-defined and the results of legal actions easy to forecast. But… the situation is quite different when market transactions are so costly as to make it difficult to change the arrangement of rights established by the law. In such cases, the courts directly influence economic activity. …Even when it is possible to change the legal delimitation of rights through market transactions, it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out.”

So… What are transaction costs, and how do we deal with them?

Transaction Costs

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 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

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

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

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.

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.)

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 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 later 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

Example of high transaction costs when there are many sellers
Second one, homeowner didn’t accept government’s buyout offer, wanted more money, government chose to build highway around house. Eventually, though, an agreement was reached and the house has now been demolished gives some other examples

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

So, what do we do?

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.

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.

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

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

So now we have one general principle we can use for designing property law
When transaction costs are low, design the law to facilitate voluntary trade When transaction costs are high, design the law to allocate rights efficiently whenever possible 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

Designing an efficient property law system

Four questions we need to answer
what can be privately owned? what can an owner do? how are property rights established? what remedies are given? We said that any property rights system must address four questions: What things can be privately owned? What can (or can’t) an owner do with his/her property? How are property rights established? And what remedies are given when they are violated? Next, we want to answer each of these, with an eye toward efficiency That is, how would an efficient property system answer each question? We’ll start with the first one

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

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

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

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

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

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

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? Next, a question we haven’t yet considered at all: remedies And we begin with an important paper (on the syllabus), by Calabresi and Melamed

we’ll probably end here – for Monday, read Calabresi and Melamed

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?

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

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

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

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.

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

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.

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

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.)

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

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

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:

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

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

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/

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 Next week, we’ll attack the other questions of how you design an efficient property law system in theory, and then move on to applications.

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.

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).

what can be privately owned? what can an owner do?
how are property rights established? what remedies are given? So that gives a general answer to the question, What can be privately owned? Efficiency says, private goods should be privately owned, public goods should not. The next question, How do I establish rights to something? we’ve seen a couple examples of this already: in whaling, and foxes (Pierson v Post) there isn’t really a general theory behind it – we can see it as an extension of the question of what can be owned we will come back to this and talk about it through some more applications Which leaves us with the question, what can an owner do with his property?

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.

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? (Examples to come) What remedies are given? Injunctions when transaction costs are low; damages when transaction costs are high

Econ 522 Economics of Law Dan Quint Spring 2013 Lecture 5.

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Econ 522 Economics of Law Dan Quint Spring 2013 Lecture 5.

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