Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 5.

Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 5

Reminder HW1 due online at noon tomorrow

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)

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 4 4

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 5 5

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 6 6

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 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!

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.

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

Let’s go back to our rancher and farmer
Do nothing: $500 in crop damage

Farmer builds fence: $300 Rancher builds fence: $400

No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights Let’s go back to our rancher and farmer Three possibilities Nobody builds a fence – $500 in damage Rancher builds fence – $400 cost Farmer builds fence – $300 cost Suppose we’re in a farmer’s rights world Rancher is liable for any damage done by his herd What does Coase predict will happen? They’ll bargain to efficient outcome Meaning, the farmer will build a fence (and the rancher will pay him) How much will he pay?

Before bargaining: threat points
No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights Before bargaining: threat points Threat point – each party’s expected outcome if bargaining fails “If we can’t agree to a deal and we go our separate ways, how well off am I?” Also called outside option, or reservation utility Deal has to make everyone better off than that!

No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights
Threat points What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point.

Threat points What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point

Gains from cooperation
No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights Gains from cooperation So under a closed-range law… The farmer’s threat point is 0, the rancher’s is –$400 Those are the payoffs that will happen if no agreement is reached If a deal happens: total payoffs go up from –$400 to –$300 Farmer will build a fence (efficient outcome), rancher will pay him some money Cooperation causes total payoffs to go up by $100 So $100 is gains from cooperation (or gains from trade)

So what will happen? Coase predicts negotiation will lead to efficiency So the gains from cooperation will be realized (The farmer will build a fence) Both sides have to do at least as well as their threat point Otherwise, wouldn’t agree to deal So rancher will pay farmer somewhere between $300 and $400 to build the fence But what if we want a more precise prediction? 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 the rancher will pay the farmer somewhere between $300 and $400

So what will happen? What if gains from cooperation were split evenly?
No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights So what will happen? What if gains from cooperation were split evenly? Threat points 0 and –400, gains of 100 Farmer’s payoff: 0 + ½ (100) = 50 Rancher’s payoff: –400 + ½ (100) = –350 How is this achieved? Rancher pays farmer $350 to build fence Many bargaining models (but not all of them) predict that the gains from cooperation will be evenly split among the parties That is, the increase in each side’s payoff, above his threat point, will be the same What would that mean here?

If gains are split evenly…
No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights If gains are split evenly… Farmer’s Rights Rancher’s Threat Point -400 Farmer’s Threat Point Gains From Cooperation 100 Rancher’s Payoff (IF…) (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 –400 + ½ (100) = –350 Farmer’s Payoff 0 + ½ (100) = 50 Combined Payoffs -300

If gains are split evenly…
No fence: $500 in harm Rancher builds fence: $400 Farmer builds fence: $300 Law: Farmer’s Rights If gains are split evenly… Rancher’s Rights Farmer’s Rights Rancher’s Threat Point -400 Farmer’s Threat Point -300 Gains From Cooperation 100 Rancher’s Payoff (IF…) (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 -350 Farmer’s Payoff -300 50 Combined Payoffs -300 = -300

One more example – you having a party next door to my house
Let’s suppose… Having the party is worth $150 to you… …and a good night’s sleep is worth $100 to me So it’s efficient to have the party If parties are allowed… No need for negotiation If parties are not allowed… My threat point: 0 Your threat point: 0 Gains from cooperation: $50 If split evenly: payoffs are $25 and $25 Which requires you paying me $125 to have the party Remember, though: Coase doesn’t specify gains will be split evenly Coase just predicts they’ll be achieved

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 28 28

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? (won’t get to this)

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

That’s it for today HW due tomorrow night at midnight
For next Monday: read Calabresi and Melamed

Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 5.

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Econ 522 Economics of Law Dan Quint Spring 2014 Lecture 5.

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