Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 4.

Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 4

Reminder HW1 due midnight tomorrow night

Discussion question Last week, we defined efficiency, and gave a couple arguments why efficiency might be a good normative goal for a legal system Posner: ex-ante consent Cooter and Ulen: better to achieve redistribution through taxes Open discussion question: Aside from efficiency, what are other plausible goals for a legal system? When would you expect them to be in conflict with efficiency?

Property Law 3 3

Why do we need property law in the first place?
We already saw one reason Tragedy of Commons – overuse of land is held in common For another example, imagine two neighboring farmers Each has two choices: farm his own land, or steal crops from his neighbor Stealing is less efficient than planting my own crops Have to carry the crops from your land to mine Might drop some along the way Have to steal at night  move slower If I steal your crops, I avoid the effort of planting and watering Once we have property, we’ll inevitably have some amount of property conflicts But why do we need private property in the first place? We’ve already seen one reason why we might want private property: the Tragedy of the Commons example from Monday 4 4

Why do we need property law in the first place?
Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3 With no legal system, the game has the following payoffs: We look for equilibrium Like Prisoner’s Dilemma both farmers stealing is the only equilibrium but that outcome is Pareto-dominated by both farmers farming Player 2 Farm Steal 10, 10 -5, 12 Farm Player 1 12, -5 0, 0 Steal 5 5

So how do we fix the problem?
Suppose there were lots of farmers facing this same problem They come up with an idea: Institute some property rights And some type of government that would punish people who steal Setting up the system would cost something Suppose it imposes a cost c on everyone who plays by the rules 6 6

So how do we fix the problem?
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 Steal Steal If P is big, and c is not too big, then 12 – P < 10 – c In that case, (Farm, Farm) is an equilibrium Payoffs are (10 – c, 10 – c), instead of (0, 0) from before 7 7

So the idea here… Anarchy is inefficient
I spend time and effort stealing from you You spend time and effort defending your property from thieves Instead of doing productive work Establishing property rights, and a legal process for when they’re violated, is one way around the problem Keep in mind, though, that there is still inefficiency here – the cost c of administering the system That is, payoffs of (10-c, 10-c) are better than payoffs of (0,0), but not as good as (10,10) 8 8

Overview of Property Law
Cooter and Ulen: property is “A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” Property rights are not absolute Appendix to ch. 4 discusses different conceptions of property rights Any system has to answer four fundamental questions: What things can be privately owned? What can (and can’t) an owner do with his property? How are property rights established? What remedies are given when property rights are violated? Cooter and Ulen define property as “a bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others.” Of course, property rights aren’t absolute. In the appendix to chapter 4, they give examples of different conceptions of property rights. Without getting into the philosophy behind a property rights system, it’s clear that a conception of property rights has to answer four fundamental questions: What things can be privately owned? Clearly not everything can be owned – nobody owns the ocean, can’t own another person, etc. Ancient Jewish law – ownership over sold land was not permanent, it reverted to its ancestral owner after 50 years Cultural artifacts; Intangible property – copyrights, patents, trademarks What can (and can’t) an owner do with his property? Again, not everything - property rights can’t be absolute, because my exercising my rights might interfere with you exercising your rights – I want to sleep, you want to have a party next door Typically, you can’t use your own property in a way that creates a nuisance to others Many of the examples when we discuss Coase will have to do with limiting what a person can do with his property. I own my kidneys, but I can’t sell one If I own a building that has historical significance, I can’t necessarily destroy it or change it in certain ways. How are property rights established? In the whaling example, what does it take to establish ownership? In many cases when government wanted to encourage migration into new areas, free land, conditional on you farming it or developing it. And on the flip side, when can property rights be revoked? Eminent domain – the government’s right to seize private property Negligent landlords. What remedies are given when property rights are violated? Rights – my right to use my property in certain ways – and prohibitions – other people can’t interfere – have no meaning unless they are enforced So how do I get compensated if my property rights are violated? 9 9

But once we have property rights, we’ll have conflicts between my rights and yours
I buy a house out in the countryside. This is my neighbor. Here’s the property line – the line separating his land from mine. One summer, I put in a pool. The next year, my neighbor plants a bunch of new trees along the property line… …and now, in the late afternoon, my pool is completely shaded. I go to my neighbor and ask him to cut down the trees, as they’re ruining my swimming pool And he says they’re on his land, and he likes them, so they stay. Who’s right? 10 10

Another story source: http://www.msnbc.msn.com/id/21088150/ 11 11
You’re marketing my leg! Amputee, opportunist wrangle over custody of limb left in barbecue smoker updated 10/2/2007 4:50:12 PM ET T20:50:12 MAIDEN, N.C. — A South Carolina man who stored his severed leg in a barbecue smoker that was later auctioned off is locked in a custody dispute with the North Carolina man who found it. John Wood's leg was amputated near the knee after a 2004 airplane crash. He asked doctors to give it to him so he could be buried as a whole man when he died. The limb, which Wood had kept in the smoker in a storage facility after he lost his home, was bought by Shannon Whisnant last Tuesday in an auction held by the storage company because Wood had missed his monthly payments. Whisnant initially gave it to police, who subsequently turned it over to a funeral home when it became clear it was not the result of foul play. But Whisnant, who put a sign on the empty smoker charging adults $3 and children $1 for a look, now wants the leg back. "He's making a freak show out of it," Wood told The Charlotte Observer for a Monday story. "He wants to put money in his pocket with this thing." Whisnant, who was unsuccessful in his bid to get the leg from the funeral home, consulted with a lawyer and decided his best move was to persuade Wood to share custody and profits. "It's a strange incident, and Halloween's just around the corner," Whisnant said. "The price will be going up if I get (a stake in) the leg." Wood, who is heading to Maiden to pick up his leg, said the two men can meet, but he is not interested in using the leg to make money. "I just think it's despicable," he said. "I don't mind having the 15 minutes of fame, but I'm not looking to really profit off this thing." © 2012 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed. source: source: 11 11

How do we design property law to achieve efficient outcomes?
Even if many property questions seem obvious, there will always be weird exceptions So we’d better come up with some general principles 12 12

One early, “classic” property law case
Pierson v. Post (NY Supreme Court, 1805) Lodowick Post organized a fox hunt, was chasing a fox Jesse Pierson appeared “out of nowhere,” killed the fox and took it Post sued to get the fox back Lower court sided with Post; Pierson appealed to NY Supreme Court Question: when do you own an animal? I mention it here not because we care that much about when you establish possession of a wild animal, but because the court – both the majority and the dissenting opinion – were explicit about considering the economic effects their ruling would lead to 14 14

One early, “classic” property law case
Court ruled for Pierson (the one who killed the fox) “If the first seeing, starting, or pursuing such animals… should afford the basis of actions against others for intercepting and killing them, it would prove a fertile source of quarrels and litigation” (Also: just because an action is “uncourteous or unkind” does not make it illegal) Dissenting opinion: a fox is a “wild and noxious beast,” and killing foxes is “meritorious and of public benefit” Post should own the fox, in order to encourage fox hunting That is, if the first to chase an animal owned it, there would be endless disputes and court cases; and so they favored a more “bright line” rule of ownership which would lead to fewer disagreements 15 15

Same tradeoff we saw earlier:
Pierson gets the fox simpler rule (finders keepers) easier to implement fewer disputes Post gets the fox more efficient incentives (stronger incentive to pursue animals that may be hard to catch) Just like Fast Fish/Loose Fish vs Iron Holds The Whale Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes Iron Holds the Whale is more complicated, but is necessary with whales where hunting them the old-fashioned way is too dangerous 16 16

Coase The decision and dissent in Pierson v Post certainly suggest that how property law is designed will matter for efficiency So we come back to the question: how should property law be designed to achieve this goal?

How should property rights be allocated?
Coase’s surprising answer: it doesn’t matter How should property rights be allocated? More specifically, under certain conditions, it doesn’t matter for efficiency (Although it does matter for distribution) Coase Theorem: in the absence of transaction costs, if property rights are well-defined and tradable, then voluntary negotiations will lead to efficiency It doesn’t matter how rights are allocated initially… …because if they’re allocated inefficiently, they can be sold/traded until they’re allocated efficiently

Example of Coase: you have a car worth $3,000 to you, $4,000 to me
Obviously, efficient for me to own it… …but we don’t need the law to give me the car If I start out owning the car: no reason for you to buy it, I end up with it  efficient If you start out owning the car: clear incentive for me to buy it, I end up with it  efficient Regardless of who owns the car at first, we get to the efficient outcome I’d rather start out with the car – so I don’t have to pay you for it You’d rather start out with it – so you end up with more money Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. And that doesn’t depend on who starts with it. The key: lack of transaction costs This is easiest to illustrate with an example we’ve already seen: your car. Since the car’s worth more to me than it is to you, we know it’s efficient for me to have the car. (Assume there are no externalities – my neighbors don’t care.) But it turns out, in order to achieve that outcome, we don’t need a law that says I get your car – all we need is for people to be allowed to buy and sell used cars. Why? If I start off with the car, then great – I have the car, there’s no reason for you to buy it from me, I keep the car, and we get efficiency. If you start off with the car, then we clearly have an incentive to come to some arrangement. Property rights have to be well-defined – it has to be clear that it’s your car, and you have to be allowed to sell it to me. But as long as that’s the case, we should be able to reach some bargain – I give you $3,500, or maybe a bit more, or maybe a bit less – and you give me the car. So I end up with the car, which is efficient. The point is, regardless of who starts off with the car, I’m going to end up with it. I’d rather I start with the car – that way, I don’t have to pay you anything. You’d rather you start with the car – that way, you end up with a bunch of my money. But for efficiency, it doesn’t matter who starts with the car - we’ll achieve efficiency (me having the car) either way. The key here is the absence of transaction costs. Basically, there can’t be any impediments to us reaching a private agreement If every time someone sold a used car, the buyer had to pay a huge tax to the government, the Coase theorem would fail We saw a few examples Tuesday of forces that lead to inefficiency – barriers to trade, taxes. These can be thought of as transaction costs. Next lecture, we’ll discuss what some sources of transaction costs are; for now, just think of them as anything that gets in the way of us trading among ourselves.

Another example: you want to have a party in the house next door to mine
If it’s efficient for you to have the party… Your benefit from having the party is greater than my benefit from a good night’s sleep If you start out with the right to have the party, no problem If I start out with the right to quiet, you can pay me for the right to have the party If it’s efficient for you not to have the party… Good night sleep is worth more to me If I have right to silence, no problem If you have right to party, I can pay you not to have it The point: either way, we achieve efficiency If it’s efficient to have the party, you have the party If it’s efficient not to, you don’t Regardless of who started off with the right The Coase theorem sounds pretty obvious when it comes to objects. If you own something, but it’s worth more to me, and there’s nothing to stop you from selling it to me, I guess you’ll end up selling it to me. Obviously. What Coase did, though, was apply this to rights, and situations with externalities, as well. I have an apartment, and you live next door, and you want to have a party on Saturday I hate noise, and don’t want you to. Should you be allowed to have the party? The point of Coase: think of the right to have the party (or to prevent it) as just another object If it’s efficient for you to have the party, that means the party is worth more to you and your guests than a good night’s sleep is worth to me Which means the “party rights” are worth more to you than they are to me If you start out with them, great If I start out with them – if the law gives me the power to prevent you from making noise – you can buy the rights from me. That is, you can pay me to allow you to have the party. And if it really is efficient for you to have the party, you and your guests can come up with enough money to buy me off, and still be better off yourselves. What if sleep is worth more to me than the party is to you? That means it’s not efficient to have the party. If I start out with the right to peace and quiet, we don’t need to do anything But if you start out with the right to have a party, I can bribe you not to. Again, for distribution, who starts off with the rights matters – since they’re worth something, we’d both rather have them But who starts off with them doesn’t matter for efficiency – we’ll get to efficiency either way

The conditions for this to hold
Property rights have to be well-defined… We need to be clear on who has what rights, so we know the starting point for negotiations …and tradable… We need to be allowed to sell/transfer/reallocate rights if we want …and there can’t be transaction costs It can’t be difficult or costly for us to buy/sell the right

The Coase Theorem Ronald Coase (1960), “The Problem of Social Cost”
In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency. So the initial allocation of rights doesn’t matter for efficiency However, it does matter for distribution And if there are transaction costs, it may matter for efficiency too

Coase’s example: a rancher and a farmer
Coase doesn’t actually write about neighbors and parties - he starts with a different example Suppose that on adjacent tracts of land, there is a cattle rancher and a farmer The rancher has cows, the farmer grows some crop – say, corn And on occasion, the rancher’s cattle will occasionally stray onto the farmer’s land and eat some of the crops So we need a rule for who’s responsible for the damage when that happens

Rancher’s versus farmer’s rights
English common law: “closed range” or “fencing-in” (or “farmer’s rights”) Ranchers have responsibility to control their cattle Rancher must pay for any damage done by his herd Much of the U.S. at various times: “open range” or “fencing-out” (or “rancher’s rights”) Rancher can let his cattle roam free Not liable for damage they do to farmer’s crops (unless farmer had a good fence and they broke through anyway) Which rule is more efficient? There are two obvious candidates for what the law could be: either the rancher is responsible for the damage his cattle did, or he isn’t

Open range versus closed range
First, let’s consider what happens under an open range law – that is, when the rancher is not liable for damage done by his herd When the rancher is deciding on the size of his herd, he weighs only the private costs and benefits, ignoring the incremental damage that a larger herd would do to his neighbor’s crops – that is, ignoring the externality he imposes So on the margin, this may lead him to a cattle herd that’s inefficiently large In addition, since he isn’t harmed by the damage done by his herd, he has no incentive to build a fence or to do anything else to rein in his herd But the farmer, faced with the prospect of damage, has a clear incentive to take any steps he can to reduce the damage – such as building a fence around his crops to keep out wandering cattle planting less planting less along the boundary between the two tracts of land or planting crops that cows don’t like along the boundary or any other steps that might also be cheaper than the damage done. Next, consider what happens under a closed range law – when the rancher is liable for any damage done by his herd Now the farmer has no reason to build a fence, or to take any other action When the rancher is deciding how big a herd to keep, he will consider the incremental damage done to his neighbor, since he has to pay for the damage; and he will consider actions that he can take to restrain his herd, like fencing in the grazing land, if that’s cheaper than paying for the damage

Coase: either law will lead to efficiency
If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd… Under open range law, that’s what he’ll do Under closed range law, rancher can pay farmer to build fence If smaller herd is more efficient, farmer can pay rancher to keep fewer cattle Coase: Whatever is the efficient combination of cattle, crops, fences, etc.… …the rancher and farmer will negotiate to that efficient outcome, regardless of which law is in place… …as long as the rights are well-defined and tradable and there are no transaction costs Coase, however, comes along, and says it doesn’t matter which law is in place – either one will lead to the same, efficient outcome If it’s cheaper for the farmer to fence in his crops, rather than the rancher fencing in his herd… Under an open range law, that will happen automatically Under a closed range law, rather than fencing in his herd, the rancher will pay the farmer to build a fence around his crops If it’s efficient for the rancher to keep a smaller herd, the farmer can pay the rancher to do so Coase’s conclusion: whatever is the most efficient combination of cattle, crops, fences, and so on, is exactly what will happen, because the rancher and farmer will negotiate to that outcome to save money Just as long as his assumptions are satisfied – property rights are well-defined and tradable, and there are no transaction costs

Rancher and farmer: numerical example
Three possibilities: Rancher builds fence around herd… costs $400 Farmer builds fence around crops… costs $200 Do nothing, live with damage… costs nothing If expected crop damage = $100 Open range: farmer lives with damage rather than building fence Closed range: rancher pays for damage rather than fence If expected crop damage = $500 Open range: farmer builds fence – efficient Coase: closed range: rancher pays farmer to build fence So efficient outcome under either rule To be more specific… Suppose there are three things that could be done about the problem: The rancher could build a fence to restrain his herd – suppose this costs $400 The farmer could build a fence to protect his crops – suppose this costs $200 Finally, they could both just do nothing, and live with the damage Now, if the damage the cattle will do is less than $200, there’s no reason to do anything Suppose the damage is only $100 it’s inefficient to build a fence – it costs more than the problem it solves in a rancher’s rights world – where the rancher is not liable for damage done by his herd – the farmer won’t choose to build a fence, he’ll just eat the $100 loss in a farmer’s rights world – where the rancher is liable – he’ll just live with paying the farmer $100 to reimburse him for the damage On the other hand, suppose the damage the cattle will do is more than $200 suppose it’s $500 then the efficient thing is for the farmer to build a fence in a rancher’s-rights world, this will happen “automatically” – the farmer would rather build a $200 fence than suffer $500 of unreimbursed damages the point of Coase: in a farmer’s-rights world, this is also what will happen – because the rancher will pay the farmer to build a fence that is, rather than face paying $500 for the damage done, and rather than spend $400 to build his own fence, he will offer the farmer some smaller amount – say, $300 – to put up a fence and the farmer will prefer that to doing nothing

Other examples from Coase
Lots of examples from case law a building that blocked air currents from turning a windmill a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door a doctor next door to a confectioner a chemical manufacturer a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation Coase gives a number of examples of specific cases in nuisance law, and repeats the point that, regardless of who is initially held responsible for the harm, negotiation and trade will lead to efficiency from any starting point Some of his other examples: An early English case of a building which was built in such a way that it blocked air currents from turning a windmill A building in Florida which cast a shadow over the swimming pool and sunbathing areas of a nearby hotel A doctor whose office was next door to a confectioner, who built a new examination room and found that the vibration from the confectionery’s machinery prevented him from listening to his patients’ chests through a stethoscope in that room A chemical manufacturer whose fumes interacted with a weaver’s products while they were drying after bleaching A house whose chimney no longer worked well after its neighbors rebuilt their house to be taller In each example, he argues that, regardless of who is held to be liable, the parties can negotiate with each other and take whatever remedy is cheapest to fix (or endure) the situation.

Quoting from Coase (p. 13):
Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved. In the case of the cattle and the crops, it is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops. The doctor’s work would not have been disturbed if the confectioner had not worked his machinery; but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place… This is an important point – Coase points out, we shouldn’t think of the problem as, “Should the rancher be allowed to harm the farmer?”, since that begs the question. Instead, we should ask the question, “Either the rancher harms the farmer, or the farmer harms the rancher; which of these situations is the more efficient?”

Quoting from Coase (p. 13):
If we are to discuss the problem in terms of causation, both parties cause the damage. If we are to attain an optimum allocation of resources, it is therefore desirable that both parties should take the harmful effects into account when deciding on their course of action. It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties. That is, both parties perceive the cost of the externality, at least as an opportunity cost.

What does Coase mean by “a cost for both parties”?
If the cheapest alternative is for the farmer to build a fence for $200… The cost to build a fence is $200 But the cost to not build a fence is more than $200 – since under a closed-range law, the farmer could ask the rancher for more than $200 to build the fence “Opportunity cost” This last part is a little subtle. But go back to our rancher-farmer example. The rancher’s cattle are doing $500 worth of damage, and the cheapest way to fix it is for the farmer to build a fence for $200 consider the farmer’s-rights world the farmer doesn’t have to build a fence – the rancher will have to build his own fence, or pay for the damage but even though he doesn’t have to build a fence, the farmer perceives the cost of not building the fence as higher than the cost of building it this is because he faces an opportunity cost the cost of building the fence is $200 the cost of not building the fence is the foregone opportunity to get the rancher to pay him MORE THAN $200 to build it If I’m causing $100 of damage to my neighbor but I could prevent it for $10, a “smoothly operating pricing system” causes me to view the cost of the externality as $100 in opportunity cost – since I could presumably get my neighbor to pay me that much money to prevent the damage.

So, summing up… 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 (But if there are transaction costs, then the initial allocation can matter for efficiency… …and it will always matter for distribution) 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)

Bargaining Since the Coase Theorem relies on parties bargaining with each other to achieve efficient outcomes, let’s talk a bit more about bargaining

Some vocabulary about bargaining
Example from before: Your car is worth $3,000 to you, and $4,000 to me Suppose I have $10,000 $10,000 is my threat point the payoff I can get on my own, by refusing to cooperate with you also called reservation utility, or outside option $3,000 is your threat point Any outcome we both agree to must make us both at least as well-off as our threat point Back to the car example. You have a car, it’s worth $3,000 to you, and it’s worth $4,000 to you. And suppose that I have $10,000, so being able to afford the car isn’t an issue. $10,000 is called my threat point It’s the level of utility that I can achieve by not trading with you – I just keep my $10,000 So there’s no reason for me to accept any outcome where I end up with less than $10,000 worth of utility This is also called my reservation utility, or my outside option, since it’s what I can get by refusing to cooperate. $3,000 is your threat point – the payoff you get from keeping the car The assumption that negotiations are voluntary – we both have to agree to any trade – means neither of us will ever accept a deal worse than our threat point

If I don’t buy the car from you… my payoff is 10,000 (my threat point) your payoff is 3,000 combined payoffs are 13,000 If I buy the car for some price P my payoff is 4, ,000 – P = 14,000 – P your payoff is P combined payoffs are 14,000 – P + P = 14,000 $1,000 are the gains from trade (or gains from cooperation) no trade  combined payoffs of $13,000 I buy car  combined payoffs of $14,000 if we cooperate, our combined payoffs increase by $1,000 Suppose we do trade. I buy the car for some price P I now have the car, worth $4,000 to me; and I still have $10,000 – P, so my payoff is $14,000 – P Yours is P, so our combined payoffs are $14,000 $1,000 are the gains from trade This is the amount of new surplus we can create if we cooperate Now, we both have to end up with at least as much utility as our threat point and our combined utilities will be $1,000 higher if we cooperate so our negotiations can be thought of as figuring out how to divide these gains that is, in the final outcome, we will each get our threat point, plus some fraction of the gains from trade

Threat points: 10,000 and 3,000 Gains from cooperation: 1,000 Suppose the gains from cooperation were split equally we’d each get 500 more than threat point my payoff would be 10,500, yours 3,500 which means P = $3,500 (Coase doesn’t specify gains will be divided equally, just that they’ll be divided in some way) There are lots of different approaches to actually modeling bargaining some are based on certain axioms or assumptions, some use game theory in this case, they all predict that I’ll sell you the car for some price between $3,000 and $4,000 we already said, if I sell you the car for some price P, that your payoff will be P and mine will be $14,000 – P so saying P will be between $3,000 and $4,000 is the same as saying, we will realize the gains from trade, and each of us will get at least our threat point in order to make a sharper prediction, sometimes we’ll assume that the gains from trade are divided equally if I value the car at $4,000 and you value it at $3,000, this means I pay $3,500 for it or, since the gains from trade are $1,000, dividing them equally means we each end up $500 better off than our outside option (threat point) Coase doesn’t say the gains from trade will be divided equally, just that they’ll be realized – that is, that we’ll achieve the efficient outcome, by reaching some agreement

Let’s go back to the rancher and farmer
Cows do $500 damage; fence around herd costs $400; fence around crops costs $200 Rancher’s Rights Farmer’s Rights Rancher’s Threat Point -400 Farmer’s Threat Point -200 Gains From Cooperation (Payoffs assume gains from trade are divided evenly) The Coase Theorem is that the bottom row is the same The initial allocation of rights does not matter for efficiency But the two sides’ payoffs are still different under the two rules – the initial allocation of rights does affect distribution Recall that we did need a couple key assumptions to predict such a nice, efficient outcome we need clear, tradeable property rights and we need a total absence of transaction costs Later today or Wednesday, we’ll look more closely at transaction costs – some of the things that can get in the way of voluntary bargaining leading to efficiency. But when there are no transaction costs, bargaining will lead to efficiency. If my car is worth more to me than it is to you, we will both find it worthwhile to come to some agreement where I get the car If the farmer can build a fence more cheaply than the rancher, they’ll both find it worthwhile to come to some agreement where that’s what happens 200 Rancher’s Payoff (IF…) -300 Farmer’s Payoff -200 100 Combined Payoffs -200 = -200

Relating Coase to general equilibrium/ first welfare theorem
given prices, consumers maximize utility given prices, firms maximize profits prices are such that all markets clear First Welfare Theorem: general equilibrium is efficient But not when there are externalities, or “missing markets” Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights Some of you may remember General Equilibrium Theory from 301 General Equilibrium is when everyone does whatever is best for them, given the prices they see consumers maximize utility, firms maximize profits, etc. and prices are such that markets all clear and the First Welfare Theorem states that General Equilibrium is always efficient. The first time I taught this class, on the second day of class, I solved an example of this a setting with two consumers one of them is a hops farmer – he had lots of hops, he ate hops, and liked beer too the other was a brewer – he didn’t own any hops, but he had a technology for turning hops into beer The first thing we did was to find the general equilibrium Given a set of prices for hops and beer, we could work out how much hops and how much beer the farmer would demand Given a set of prices, we could also work out how much beer the brewery would produce to maximize profits And then we found the set of prices such that markets cleared And we showed, as expected, that the result was efficient Next, we worried about externalities Suppose the farmer hates the smell emanating from the brewery But there are no environmental controls – the brewery can do whatever it wants Because the externality, the general equilibrium is now inefficient the farmer would like the brewery to brew less beer, so the smell is weaker but he has no control over market prices

Relating Coase to general equilibrium/ first welfare theorem
given prices, consumers maximize utility given prices, firms maximize profits prices are such that all markets clear First Welfare Theorem: general equilibrium is efficient But not when there are externalities, or “missing markets” Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights But then comes Coase, and he says that the farmer could just negotiate with the brewer Farmer says look, how about instead of paying you $9 per six-pack for this many beers, I’ll pay you a little more for a little fewer That way, you can produce less beer, but still earn higher profit So they reach an agreement, and it’s efficient And the point of Coase is that, whoever starts off with the “air rights,” we’ll get to efficiency If the brewery starts off with the right to pollute, the farmer can negotiate a reduction in pollution If the farmer starts off with the right to breathe clean air, the brewery can go to him and negotiate rights to pollute some And in either case, they’ll reach an efficient outcome They’ll be different outcomes – if the farmer starts off with the right, he’ll end up richer, and able to consume more, than if the brewery does – but in either case, the outcome will be efficient. So another way to think about Coase is to say that we can overcome externality problems by expanding property rights to include whatever is causing the externality The problem with an externality is that it’s something that enters your utility function, but there’s no market for it By creating a market for “air rights” – that is, by turning “air rights” into a tradeable good – we can use the pricing system to get to efficiency, regardless of who starts off owning these rights.

Getting back to foxes…

Doesn’t Coase make Pierson v Post irrelevant?
Coase seems to say: for efficiency, it doesn’t matter who starts off with the right to the fox If Post values it more, he can buy it from Pierson, or vice versa Seems to imply: one rule is just as good as the other, as long as we all know what the rule is So why does Pierson v Post matter? Transaction costs! Majority: if Post gets the fox back, “it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly Dissent: killing foxes is a good thing (externality), so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining We started today’s lecture talking about Pierson v Post, the fox hunt case Both the majority and the dissenting opinion seemed to imply the ruling mattered for efficiency Majority wanted to reduce the number of fox cases that ended up in court Dissent wanted to get more people to hunt foxes But we just saw the Coase theorem, which says that the initial allocation of rights shouldn’t matter for efficiency As long as we all know what the rule is, and can bargain around it, any rule is just as good as another So why doesn’t Coase make the actual ruling irrelevant? The Coase Theorem required a complete absence of transaction costs But in the real world, there sometimes are transaction costs The situation the Pierson court was concerned with – lots of lawsuits in the future – is exactly a transaction cost If we allow ownership based on “I saw the fox first”, people will constantly be suing each other for foxes… …and those lawsuits waste time and money! The situation the dissent was concerned with – not enough foxes being hunted – is also related to transaction costs They write that killing foxes is of public benefit – that it has an externality This means that lots of people are affected by someone’s decision to hunt foxes But as we’ll discuss Wednesday, bargaining is very difficult – and/or costly – when lots of people are involved So it may be very hard to achieve the efficient level of fox hunting through negotiations! Coase says, in situations with no transaction costs, the initial allocation of rights doesn’t affect efficiency But lots of real-world situations do indeed have transaction costs

Transaction costs Coase: “in the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.” This suggests that if there are transaction costs, voluntary negotiations may not lead to efficiency Car example (yet again) If transactions are costly, we may not trade And if we do trade, we incur that cost Recall our statement of the Coase Theorem: In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency, and the initial allocation of property rights won’t matter for efficiency. But this also suggests the converse might be true: when private negotiations are not costless, or transaction costs are not zero, that we may not get efficiency, and initial allocations may matter. When there are transaction costs, we can get inefficiencies for two reasons: first, when transaction costs are high, they will prevent certain trades that would have been beneficial if your car is worth $3,000 to you and $4,000 to you, but it would cost us $2,000 to find each other and transact, you’ll keep the car and second, any resources actually spent overcoming the transaction costs are, in a sense, wasted if it costs us $500 to find each other and transact, we’ll still do it, but we will have lost that $500

Quoting Coase… “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.

We can see the Coase Theorem as either a positive or negative result
“In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.” We can read this as… “As long as transaction costs aren’t a big deal, we’ll get efficiency” Or as, “we’ll only get efficiency automatically if there are no transaction costs” Coase also gives two examples of institutions that may emerge in response to high transaction costs: Firms Government regulation Coase offers two examples of institutions that may emerge in response to high transaction costs: firms, and government regulation Suppose it is very difficult or costly for the rancher and the farmer to come to an agreement among themselves. One solution is for the ranch and the farmland to be both be purchased and operated by the same firm. Then the firm balances the costs and benefits of both activities, and makes decisions (what fence to build, how big a herd to raise) to maximize the total value of production The second example, government regulation, is the same idea, since he imagines the government as a sort of “super-firm” which considers the costs and benefits of each activity to everyone.

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!

That’s it for today HW1 due (online submission) midnight tomorrow
For Monday Demsetz, “Toward a Theory of Property Rights” Calabresi and Melamed, “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral” No class next Wednesday

Demsetz (won’t get to)

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 48 48

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 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 Of course, Coase wasn’t completely ignoring costs… Next week: what are transaction costs, how do we deal with them? 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

Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 4.

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Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 4.

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