Econ 522 Economics of Law

Dan Quint Spring 2011 Lecture 4

So far, we have

defined some important tools

defined efficiency, and gave reasons for why we might want the law to be designed to be efficient showed how externalities (among other things) lead to inefficiency introduced static games, the matrix representation of payoffs, and how to find equilibria

showed two ways in which a lack of clear property rights can lead to severe inefficiencies

overfishing example farming/stealing game

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Once we have private property rights, well have conflicts between mine and yours
My neighbor likes tall trees

can he plant a tree on his property if it shades my pool, or blocks my view?

You want to have a party

do you have the right to make noise in your house? or do I have the right to a good nights sleep in my house?

I own a small power plant located on a river

do I have a right to use water from the river for cooling? do I have a right to pollute as much as I want?
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Up next: how should we design property rights to achieve efficiency?

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

Doesnt tell us how property law should be designed Need to answer four fundamental questions:

What things can be privately owned? What can (and cant) an owner do with his property? How are property rights established? What remedies are given when property rights are violated?

Today: wild animals and Coase

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Foxes

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?

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

Same tradeoff we saw earlier:

Pierson gets the fox

Post gets the fox

simpler rule (finders keepers) easier to implement fewer disputes

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
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Coase

How should property rights be allocated? Coases surprising answer: it doesnt matter
More specifically, under certain conditions, it doesnt 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 doesnt matter how rights are allocated initially because if theyre allocated inefficiently, they can be sold/traded until theyre 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 dont 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

Id rather start out with the car so I dont have to pay you for it Youd rather start out with it so you end up with more money Efficiency doesnt care about distribution how much money we each end up with just who ends up with the car at the end. And that doesnt depend on who starts with it.
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The key: lack of transaction costs

Another example: you want to have a party in the house next door to mine
If its efficient for you to have the party

Your benefit from having the party is greater than my benefit from a good nights 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 its 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
If its efficient to have the party, you have the party If its efficient not to, you dont Regardless of who started off with the right

The point: either way, we achieve efficiency

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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 cant be transaction costs

It cant be difficult or costly for us to buy/sell the right

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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 doesnt matter for efficiency

However, it does matter for distribution

And if there are transaction costs, it may matter for efficiency too
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Coases example: a rancher and a farmer

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Ranchers versus farmers rights

English common law: closed range or fencing-in (or farmers 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 ranchers rights)

Rancher can let his cattle roam free Not liable for damage they do to farmers crops (unless farmer had a good fence and they broke through anyway)

Which rule is more efficient?

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Open range versus closed range

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Coase: either law will lead to efficiency

If its cheaper for the farmer to protect his crops than for the rancher to control his herd

Under open range law, thats what hell 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 17

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
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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
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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 doctors 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
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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.
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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

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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)
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Bargaining

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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
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Some vocabulary about bargaining

If I dont 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 + 10,000 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

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Some vocabulary about bargaining

Threat points: 10,000 and 3,000 Gains from cooperation: 1,000 Suppose the gains from cooperation were split equally

wed each get 500 more than threat point my payoff would be 10,500, yours 3,500 which means P = $3,500

(Coase doesnt specify gains will be divided equally, just that theyll be divided in some way)

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Lets go back to the rancher and farmer

Cows do $500 damage; fence around herd costs $400; fence around crops costs $200
Ranchers Rights Farmers Rights

Ranchers Threat Point

Farmers Threat Point Gains From Cooperation Ranchers Payoff (IF) Farmers Payoff Combined Payoffs

0
-200 0 0 -200 -200

-400
0 200

-300 100 -200

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Relating Coase to general equilibrium/ first welfare theorem

General equilibrium

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

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Relating Coase to general equilibrium/ first welfare theorem

General equilibrium

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

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Getting back to foxes

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Doesnt Coase make Pierson v Post irrelevant?

Coase seems to say: for efficiency, it doesnt 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
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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
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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.
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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 arent a big deal, well get efficiency Or as, well 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

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Many externalities can be thought of as missing property rights

Overfishing in communal lake?

Its because property rights over those fish arent well-defined

Firm polluting too much?

Its because property rights over clean air arent 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!
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Demsetz

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We motivated property law by looking at a game between two neighboring farmers

ORIGINAL GAME
Player 2 Farm Player 1 Farm 10, 10 Steal Player 1 -5, 12 Farm

MODIFIED GAME
Player 2 Steal

Farm 10 c, 10 c -5 c, 12 P Steal 12 P, -5 c

Steal

12, -5

0, 0

-P, -P

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
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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.
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Harold Demsetz (1967), Toward a Theory of Property Rights

Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization. Private ownership of land among Native Americans

Cost of administering private ownership: moderate Before fur trade

externality was small, so gains from internalization were small gains < costs no private ownership of land

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Harold Demsetz (1967), Toward a Theory of Property Rights

Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization. Private ownership of land among Native Americans

Cost of administering private ownership: moderate Before fur trade

externality was small, so gains from internalization were small gains < costs no private ownership of land externality grew, so gains from internalization grew gains > costs private property rights developed
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As fur trading developed

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.
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Friedman tells a similar story: we owe civilization to the dogs

There is a problem with this solution Private property does not enforce itself. Someone has to make sure that the lazy neighbor doesnt 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.

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Friedman tells a similar story: we owe civilization to the dogs

Agricultural land continues to be treated as a commons for another thousand years, until somebody makes a radical technological innovation: the domestication of the dog. Dogs, being territorial animals, can be taught to identify their owners 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, Laws Order, p. 118

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So

Coase: if property rights are complete and tradeable, well 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 wasnt completely ignoring costs

Next week: what are transaction costs, how do we deal with them?
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