CONTRACTS – Exceptions To Coase’s Theorem – Empty Core October 31, 2006

1. CONTRACTS – Exceptions To Coase’s Theorem – Empty Core October 31, 2006

2. Exceptions to the Theorem of Coase • Coase Theorem • Exceptions To Coase Theorem • Transaction Costs - October 17, 2006 • Asymmetric Information - October 24, 2006 • Empty Core - October 31, 2006

3. Exceptions to the Theorem of Coase • COLOUR CODE FOR GRAPHS • Marginal Cost Curve for Agent (firm, individual) under a strict liability rule • Marginal Cost Curve for Agent (firm, individual) under a no liability rule • Marginal Cost Curve for Agent (firm, individual) under a negotiated contract that follows the Theoem of Coase • Demand Curve for the Agent’s output • Marginal Revenue Curve

4. Exceptions to the Theorem of Coase • COLOUR CODE FOR GRAPHS • Expected Marginal Cost Curve for Agent (firm, individual)

5. Exceptions to the Theorem of Coase • COLOUR CODE FOR GRAPHS (con’t) • Average Cost Curve for Agent (firm, individual) with no transaction costs • Average Cost Curve for Agent (firm, individual) with transaction costs • Profit of Agent (firm, individual) • Portion of profit traded in exchange for property rights • Portion of profit lost due to a trade in property rights • Portion of profit lost due to transaction costs

6. Theorem of Coase Review Exceptions to the Theorem of Coase

7. Before Coase The common law was believed to have had little practical deterrence against polluters. Excise taxes or fines were proposed as the “efficient” way of internalizing the cost of harm against property owners While not diminishing the precautions taken by victims of such harm.

8. Before Coase The polluter pays the marginal cost of the harm it causes. The victim must not receive a payment for the harm endured if that harm could have been avoided by the victim at lesser cost.

9. Theorem of Coase The contract replaces the market as the Pareto improving mechanism Social surplus increases and is Pareto optimal under the Coasean contract. The least cost available Pareto improving technology is applied No party can be worse off. Pareto optimal social surplus means efficient use the property. Incompatible uses are converted to compatible uses. Social surplus is improved by the same amount irregardless of which Agent has been granted property rights. The distribution of the “equally improved” surplus can vary depending on which agent has the property rights. Property rights are exchangeable or transferable. A “market” for such property rights is possible

10. Theorem of Coase • In Sudbury, Ontario the government enacted “smoke easements” that were purchased by and transferable to the air polluters

11. Theorem of Coase • Agent 1 • Agent 2 P D CMC Maximum Joint Social Surplus S S PM a1 a2

12. Exceptions to the Theorem of Coase Exceptions to the Theorem of Coase

13. Exceptions to the Theorem of Coase The Coase theorem collapses under high transaction costs many parties asymmetric information coalitional instability (empty core)

14. Exceptions to the Theorem of Coase Transaction Costs Exceptions to the Theorem of Coase

15. Exceptions to the Theorem of CoaseTransaction Costs • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 P D SATC+TC S = MC1 LATC S MC1 SATC SATC PM PPC Transaction Costs a1

16. Exceptions to the Theorem of CoaseTransaction Costs • High Transaction Low Transaction Costs Costs INJUNCTION DAMAGES

17. Exceptions to the Theorem of CoaseTransaction Costs What is the most efficient or most socially optimal way of enforcing a strict liability rule: (a) damages only (b) damages and injunction

18. Exceptions to the Theorem of CoaseTransaction Costs Under a no liability rule, with: (a) one polluter (b) many property owners harmed high transactions costs prevent a collective bribe without avoidance of free riding

19. Exceptions to the Theorem of CoaseTransaction Costs Under a strict liability rule, with: (a) one polluter (b) many property owners harmed One owner could hold out for a bribe that would extract the entire surplus of the polluter.

20. Exceptions to the Theorem of CoaseTransaction Costs Under the strict liability rule, with: (a) one polluter (b) many property owners harmed The “damages only” approach has been applied in the United States by adoption of the “reasonable use” doctrine

21. Exceptions to the Theorem of CoaseTransaction Costs • As McKie v. KVP showed, the common law applied by the courts in Canada did not adopt the “damages only” approach • In both the Sudbury and KVP cases, the legislature applied a “damages only” rule in the interests of local economics

22. Exceptions to the Theorem of CoaseTransaction Costs If two or more owners hold out, the polluter would have to shut down This is what Justice Middleton believed to be the case with Sudbury farmers when he denied them injunctive relief but damages only against the air polluters

23. Exceptions to the Theorem of CoaseTransaction Costs • It may be less costly for the polluters to internalize the pollution than to incur the transaction costs to ascertain the true level of harm in damages. • studies • experts • hiring lawyers • going to court

24. Exceptions to the Theorem of CoaseTransaction Costs • Professor Dewees concluded that injunctive relief, if this had been allowed by Justice Middleton, at Sudbury, might have succeeded in forcing the companies to internalize the costs and pursue optimal abatement

25. Exceptions to the Theorem of CoaseTransaction Costs • T = 0 and Imperfect Information: • If a "polluter" cannot be persuaded to settle for damages, because they suspect the “owner" is cheating, a tougher remedy is the injunction which can force a firm to shut down. • So the polluter might be more inclined to "agree" to internalize the costs rather than risk being shutdown. (Note - on the evidence this approximates the K.V.P. case)

26. Exceptions to the Theorem of CoaseTransaction Costs • In the wake of the Sudbury and KVP cases, the expansion of government invention in the market place came through various boards such as public health, regulation of professionals, slum housing, and local pollution.

27. Exceptions to the Theorem of Coase Asymmetric Information Exceptions to the Theorem of Coase

28. Exceptions to the Theorem of CoaseAsymmetric Information • Rules that compensate for market failures • (a) moral hazard • (b) adverse selection

29. Exceptions to the Theorem of CoaseAsymmetric Information • High Transaction Low Transaction Costs Costs INJUNCTION DAMAGES PERFECT INFORMATION DAMAGES INJUNCTION IMPERFECT INFORMATION

30. Exceptions to the Theorem of Coase Asymmetric Information What is the most efficient or most socially optimal way of enforcing a strict liability rule: (a) damages only (b) damages and injunction

31. Exceptions to the Theorem of CoaseAsymmetric Information • Protection of Possession • In trespass actions, where intent to interfere with property rights is evident, the injunction against the trespasser is available. • This is especially true when transaction costs are high.

32. Exceptions to the Theorem of Coase Asymmetric Information Under the strict liability rule, the “damages only” approach becomes inefficient if the courts underestimate the damages – for example – the harm is ongoing

33. Exceptions to the Theorem of CoaseAsymmetric Information • In Sudbury, Ontario the government measures underestimated the damages imposed on the farmers by the air polluters – for example – future damages when the harm is ongoing

34. Exceptions to the Theorem of CoaseAsymmetric Information • In Sudbury, Ontario why did INCO build the world’s tallest smokestack? • Required by technology? • Render air pollution identification more difficult so that private nuisance suits are more difficult to prove or • Prosecution under the Ontario Environmental Pollution Act more likely to be unsuccessful

35. Exceptions to the Theorem of Coase Asymmetric Information – Breach Of Contract Exceptions to the Theorem of Coase

36. Exceptions to the Theorem of CoaseAsymmetric Information • . CONTRACT BREACH OF CONTRACT PERFORMANCE OF CONTRACT

37. Exceptions to the Theorem of CoaseAsymmetric Information • a1 = level of precaution invested by the agent-promisor (Agent 1) against breach of contract against (Agent 2) • a2 = level of reliance invested by the agent-promisee (Agent 2) in Agent 1 (polluter)

38. Exceptions to the Theorem of CoaseAsymmetric Information • p(a1) = Probability of No Breach • Probability of Performance • A Completed Contract • p’(a1) > 0 • More effort results in more precaution against breach • p’’(a1) < 0 • Diminishing “returns” to precaution as more effort invested

39. Exceptions to the Theorem of CoaseAsymmetric Information • p(a1) = Probability of No Breach • Why would one expect a1 to be suboptimal without a rule? • A2 cannot observe a1 • A1 knows that A2 cannot observe a1 • A1 will apply less that optimal a1 unless it can be assured that doing so will not minimize TOTAL expected damages

40. Exceptions to the Theorem of CoaseAsymmetric Information • “Liability rule” or “liability marginal cost curve” for Agent 1 is added in orange to the joint social surplus of the parties • Max [p(a2)RP(a1) + [1 - p(a2)]RNP(a1)] - a1- a2 - [1-p(e2)]De

41. Exceptions to the Theorem of Coase Asymmetric Information • Imperfect Information • Decreasing Marginal Costs Due to Precaution • Increasing Marginal Costs Due To Production $C1 Strict Liabilty Rule –MC1 Contracted Liability Rule – MC1 Expected Liability – MC1 a1

42. Exceptions to the Theorem of CoaseAsymmetric Information • If the expectation damages rule is focused entirely on A1 this will create a second or “double” moral hazard • What is it? • A1 cannot observe a2 • A2 knows that A1 cannot observe a2 • A2 will apply less that optimal a2 unless it can be assured that doing so will not maximize TOTAL expected damages it receives from A1

43. Exceptions to the Theorem of CoaseAsymmetric Information • p(a1U a2) = Probability of No Breach • p(a1U a2) = p(a1) + p(a2) - p(a1 ∩ a2) • p(a1U a2) = p(a1) + p(a2) - p(a1 )p(a2)

44. Exceptions to the Theorem of CoaseAsymmetric Information • 1 - p(a1U a2) = Probability of Breach • p(a1U a2) = 1 - p(a1) - p(a2) + p(a1 )p(a2)

45. Exceptions to the Theorem of Coase Asymmetric Information - Screening Exceptions to the Theorem of Coase

46. Exceptions to the Theorem of Coase • . CONTRACT BREACH OF CONTRACT PERFORMANCE OF CONTRACT HIGH DISCLOSURE PARTY LOW DISCLOSURE PARTY

47. A principal in a private bilateral contract relationship writes a contract that may serve to “sort” or “separate” agents into more efficient contracts A court in a private bilateral agency relationship writes a rule that may serve to “sort” or “separate” contracts into more efficient outcomes Exceptions to the Theorem of CoaseAsymmetric Information - Screening

48. Expectation DamagesHadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 A Court imposes a “complete” rule with the agents and principals In this case two “different” agents – “two” different contracts “two” different rules H – high disclosure principal and agent L- low disclosure principal and agent EH EL

49. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 The objective of the rule is that the two (2) types of principals reveal themselves through the choice of disclosure the principals reveal and the agents receive This results in two distinct and separate damages measures for two distinct and separate principals (buyers, plaintiffs)

50. Expectation Damages Hadley v. Baxendale (1854), 9 Ex. 341, 156 E.R. 145 EH