Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2017 Lecture 6

2. Property law – our story so far • Coase: absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation • So we can always get efficient outcomes “automatically”… • …provided there are no transaction costs • But… • Demsetz: more complete property rights are costly, it’s not always worth it • And: what about when there are transaction costs? 1

3. Different types/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

4. (Cool example of hostility as a bargaining cost)

5. Two approaches we could take • Design the law to minimize transaction costs • “Lubricate private bargaining” • (Normative Coase) • Design the law to minimize dependence on bargaining • Or, minimize losses due to bargaining failures • Or, aim to allocate rights efficiently • (Normative Hobbes)

6. When is each approach best? • When transaction costs are low (and info costs are high), design the law to facilitate voluntary trade • When transaction costs are high (and info costs are low), design the law to allocate rights efficiently when possible

7. Today • More principles for designing an efficient property law system • But first…

8. An experiment on“Coasian bargaining”

9. Experiment: Coasian bargaining • Round 1 (full information) • Ten people, five of them have a poker chip to start • Each person is given a personal value for a poker chip • At the end of the round, that’s how much you can trade in a chip for • Purple chip is worth that number, red chip is worth 2 x your number • So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it • Each person can only sell back one chip • Your number is on your nametag (common knowledge)

10. Experiment: Coasian bargaining • Round 2 (private information) • Ten people, five of them have a poker chip to start • Each person is given a personal value for a poker chip • At the end of the round, that’s how much you can trade in a chip for • Purple chip is worth that number, red chip is worth 2 x your number • So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it • Each person can only sell back one chip • Only you know your number

11. Experiment: Coasian bargaining • Round 3 (uncertainty) • Six people, three poker chips • Value of each chip is determined by a die roll • If seller keeps the chip, it’s worth 2 x roll of the die • If new buyer buys chip, it’s worth 3 x roll of the die • No contingent trades – buyer must pay cash • Nobody sees the die roll until the end

12. Experiment: Coasian bargaining • Round 4 (asymmetric information) • Six people, three poker chips • Value of each chip is determined by a die roll • If seller keeps the chip, it’s worth 2 x roll of the die • If new buyer buys chip, it’s worth 3 x roll of the die • No contingent trades – buyer must pay cash • Seller knows the outcome of the die roll, buyer does not

13. What would an efficient property rights system look like?

14. Four questions we need to answer what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

15. Calabresi and Melamed treat property and liability under a common framework • Calabresi and Melamed (1972), Property Rules, Liability Rules, and Inalienability: One View of the Cathedral • Liability • Is the rancher liable for the damage done by his herd? • Property • Does the farmer’s right to his property include the right to be free from trespassing cows? • Entitlements • Is the farmer entitledto land free from trespassing animals? • Or is the rancher entitledto the natural actions of his cattle? 14

16. Three possible ways to protect an entitlement • Property rule / injunctive relief • Violation of my entitlement is punished as a crime • (Injunction: court order clarifying a right and specifically barring any future violation) • But entitlement is negotiable (I can choose to sell/give up my right) 15

17. Three possible ways to protect an entitlement • Property rule / injunctive relief • Violation of my entitlement is punished as a crime • (Injunction: court order clarifying a right and specifically barring any future violation) • But entitlement is negotiable (I can choose to sell/give up my right) • Liability rule / damages • Violations of my entitlement are compensated • Damages– payment to victim to compensate for damage done • Inalienability • Violations punished as a crime • Unlike property rule, the entitlement cannot be sold 16

18. Comparing injunctive relief to damages rule • Injurer always prefers a damages rule • Injuree (person whose entitlement is violated) always prefers a property rule • Why? Under a property rule… • Punishment for violation is severe • If the two sides need to negotiate to trade the right, injurer’s threat point is lower • Even if both rules eventually lead to the same outcome, injurer will probably have to pay more • Under a damages rule, injurer has the option to just violate and reimburse – so a higher threat point 17

19. Comparing injunctive relief todamages – example E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 • Electric company (E) emits smoke, which dirties the laundry at laundromat next door (L) • E earns profits of 1,000 • Without smoke, L would earnprofits of 300 • Smoke reduces L’s profits from 300 to 100 • E could stop polluting at cost 500 • L could prevent the damage at cost 100 18

20. First, we consider thenon-cooperative outcomes E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 • Polluter’s Rights (no remedy) • E earns 1,000 • L installs filters, earns 300 – 100 = 200 • Laundromat has right to damages • E earns 1,000, pays damages of 200  800 • L earns 100, gets damages of 200  300 • Laundromat has right to injunction • E installs scrubbers, earns 1,000 – 500 = 500 • L earns 300 19

21. Noncooperative payoffs E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 Polluter’s Rights Damages Injunction E payoff(non-coop) 1,000 800 500 L payoff(non-coop) 200 300 300 Combined payoff (non-coop) 1,200 1,100 800 20

22. What about with bargaining? E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 Polluter’s Rights Damages Injunction E payoff(non-coop) 1,000 800 500 L payoff(non-coop) 200 300 300 Combined payoff (non-coop) 1,200 1,100 800 Gains from Coop 0 100 400 E payoff (coop) 1,000 850 700 800 + ½ (100) 500 + ½ (400) L payoff (coop) 200 350 500 300 + ½ (100) 300 + ½ (400) Combined 1,200 1,200 1,200 21

23. Comparing injunctions to damages… E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 • Injunctions are generally cheaper to administer • No need for court to calculate amount of harm done • But damages are generally more efficient when bargaining is impossible Damages Injunction E payoff(non-cooperative) 800 500 L payoff(non-cooperative) 300 300 Combined payoff (non-cooperative) 1,100 800 22

24. Comparing injunctions to damages… • Injunctions are generally cheaper to administer • No need for court to calculate amount of harm done • But damages are generally more efficient when bargaining is impossible • In general, three possibilities: injurer prevents harm, injuree prevents harm, nobody prevents harm (someone pays for it) • Efficiency: cheapest of the three • Damages: injurer can prevent harm or pay for it; injurer chooses whichever is cheapest • Injunction: injurer can only prevent harm 23

25. So now we know… • Any rule leads to efficient outcomes when TC are low • Injunctions are cheaper to implement • Damages lead to more efficient outcomes when TC high • Leads Calabresi and Melamed to the following conclusion: When transaction costs are low, a property rule (injunctive relief) is more efficient When transaction costs are high, a liability rule (damages) is more efficient 24

26. Exactly agrees with principle from last week • Transactions costs low  design law to facilitate trade • Property rule does this: clarifies right, allows trade • Transaction costs high  design law to minimize losses due to failures of private bargaining • Liability rule does this: gives injurer ability to violate entitlement when efficient, even without prior consent 25

27. High transaction costs  damagesLow transaction costs  injunctive relief “Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy. On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.” (Cooter and Ulen) 26

28. Low transaction costs  injunctive relief • Cheaper for the court to administer • With low transaction costs, we expect parties to negotiate privately if the right is not assigned efficiently • But… do they really? • Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral • 20 nuisance cases: no bargaining after judgment “In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining… Frequently the parties were not on speaking terms... …The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.” 27

29. A different view of the high-transaction-costs case… “When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely. Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.” (Cooter and Ulen) 28

30. Third way to protect an entitlement: inalienability • Inalienability: when an entitlement is not transferable or saleable • Allocative externalities(enriched uranium) 29

31. Third way to protect an entitlement: inalienability • Inalienability: when an entitlement is not transferable or saleable • Allocative externalities(enriched uranium) • “Indirect” externalities(human organs) 30

32. Third way to protect an entitlement: inalienability • Inalienability: when an entitlement is not transferable or saleable • Allocative externalities(enriched uranium) • “Indirect” externalities(human organs) • Paternalism source: http://www.shanghaidaily.com/nsp/National/2011/06/02/Boy%2Bregrets%2Bselling%2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/ 31

33. Another interpretation of inalienability: bans on “repugnant markets” • “Repugnant markets” • markets that are illegal because people find them morally or aesthetically objectionable • CA ban on serving horse and dog meat • Payingbirth mother to adopt a child • Bans on dwarf tossing • Ticket scalping, price gouging, gambling, drugs, prostitution • Roth: repugnance an important constraint on markets • What people find repugnant changes over time • Charging interest used to be repugnant! • Repugnance has to be considered in practical market design 2012 Nobel Prize winner Al Roth Dwarf tossing

34. Recapping our conclusions on remedies… • When transaction costs are low, use injunctive relief • Either rule will lead to efficient allocation (Coase)… • …but injunctions are cheaper to implement (court doesn’t have to assess level of harm) • When transaction costs are high, use damages • If bargaining is impossible, damages  more efficient outcomes • (Example: polluter can choose to pollute and pay when that’s more efficient than preventing the damage) • Agrees with principle from last week • TC low: design law to facilitate trade (normative Coase) • TC high: design law to not rely on bargaining (normative Hobbes) 33