Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2017 Lecture 10

Reminders • Homework 2 due Thursday at midnight • Midterm 1 next Wednesday (Mar 1) • covers through the end of property law

Last time: • Remedies • Temporary versus permanent damages – when is each one preferable? • Several limitations and exceptions to property law • Adverse possession/squatter’s rights • Private necessity (emergencies) • Unbundling • Eminent domain/governmental “takings” • Today: regulation

Regulation 3

Recall the question: when should resources be privately owned? • Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance • Cost of public ownership: congestion and overuse • An economically rational society will privatize a resource when boundary maintenance costs are less than the waste from overuse of the resource.

Recall the question: when should resources be privately owned? • Cost of private ownership: owners must take steps to make the resource excludable – boundary maintenance • Cost of public ownership: congestion and overuse • An economically rational society will privatize a resource when boundary maintenance costs are less than the waste from overuse of the resource. • (either because congestion got worse… • or because boundary maintenance became cheaper)

This leaves the question: • For resources that aren’t privatized, how should they be provided?

Multiple forms of public ownership • Open Access • Anyone free to use the resource • Leads to overutilization (Tragedy of the Commons) • Example: oyster beds • Unanimous Consent • Opposite of open access – multiple owners must all agree to any use of the resource • Leads to underutilization • Example: empty storefronts in post-Communist Moscow • “Anti-commons” caused by existing intellectual property • Political Control/Regulation 7

Third form of public ownership: political control/regulation Dividing the mountain pasture among individual owners would require fencing it, which is prohibitively expensive. Instead, the highland pasture is held in common, with each village owning different pastures that are separated by natural features such as lakes and mountain peaks. If each person in the village could place as many sheep as he or she wanted in the common pasture, the meadows might be destroyed and eroded by overuse. 8

Third form of public ownership: political control/regulation In fact, the common pastures in the mountains of Iceland have not been overused and destroyed, because the villages have effective systems of governance. They have adopted rules to protect and preserve the common pasture. The sheep are grazed in common pasture in the mountains during the summer and then returned to individual farms in the valleys during the winter. The total number of sheep allowed in the mountain pasture during the summer is adjusted to its carrying capacity. Each member of the village receives a share of the total in proportion to the amount of farmland where he or she raises hay to feed the sheep in the winter. 9

Similar to how Iceland maintains fishing stock • Open access would lead to overfishing, deplete fishing stock • Government of Iceland decides how much fish should be caught in total each year • People own permits which are right to catch a fixed fraction of each year’s total • Permits are property – can be bought, sold, etc. 10

Regulation 11

Regulation: Pennsylvania Coal v. Mahon • 1800s: PA Coal purchased mineral and support estates, Mahon owned surface • 1921: Kohler Act prohibited “mining of anthracite coal in such a way as to cause the subsidence of, among other things, any structure used as a human habitation.” • PA Coal sued government, claiming the regulation was same as seizing their land (without compensation) • “…While property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking.” surface estate support estate mineral estate 12

Blume and Rubinfeld, “Compensation for Takings: An Economic Analysis” • Support compensation for regulatory takings • Shifting burden of regulation from owners of affected property to all taxpayers • Equivalent to selling everyone insurance against harmful regulation • If such insurance were available, people would buy it • But it’s not available, for usual reasons insurance markets may fail • adverse selection • moral hazard • So government should provide it instead… • …by paying compensation for regulatory takings 16

Blume and Rubinfeld, “Compensation for Takings: An Economic Analysis” • Support compensation for regulatory takings • Shifting burden of regulation from owners of affected property to all taxpayers • Equivalent to selling everyone insurance against harmful regulation • If such insurance were available, people would buy it • But it’s not available, for usual reasons insurance markets may fail • adverse selection • moral hazard • So government should provide it instead… • …by paying compensation for regulatory takings 17

Zoning • Zoning laws • Distinguish industrial areas from residential areas 18

Zoning • Zoning laws • Distinguish industrial areas from residential areas • Nollan v California Coastal Commission (US Sup Ct, 1987) • Nollans owned coastal property • Asked for permit to expand building, which would diminish view • Commission: donate a public walking path, and you get permit • Supreme Court: such a deal only legal if there is clear connection – a nexus – between the harm being done and the remedy 19

Zoning • Zoning laws • Distinguish industrial areas from residential areas • Nollan v California Coastal Commission (US Sup Ct, 1987) • Nollans owned coastal property • Asked for permit to expand building, which would diminish view • Commission: donate a public walking path, and you get permit • Supreme Court: such a deal only legal if there is clear connection – a nexus – between the harm being done and the remedy 20

Property law: the big-picture question • What are benefits and costs of… • having property rights at all? • expanding property rights to cover more things? • introducing an exception/limitation to property rights? • When will benefits outweigh the costs? End of material on first midterm • Up next: contract law 21

Contract Law

Looking back • The question we’ve posed: • Suppose we set up the rules, and then everyone does what’s best for them under those rules. • What rules do we set up, if we want efficient outcomes? • A couple of the ideas we’ve seen so far • Coase: initial rules don’t matter if no transaction costs (if all rights are well-defined and tradeable) • “More complicated” rules (such as more extensive property rights) lead to more efficient use of a resource, but also higher costs • Injunctive relief when transaction costs low, damages when high

So far, we haven’t worried about the details of trade • When two parties want to reallocate rights… • I want to buy your used car • Or you want to “buy” my permission to have a noisy party • Or neighbors want to pay a factory to pollute less • …we’ve assumed they can do so… • …subject (possibly) to there being some transaction costs

Timing of transactions • Some transactions happen all at once • I hand you a check for $3500, you hand me the keys to your car • There might be search costs and bargaining costs… • …but no enforcement costs • But some don’t • Neighbors pay the factory to pollute less going forward • Need to make sure factory sticks to the agreement • What if technology changes and factory wants to start polluting more again?

Lots of transactions don’t take place all at once • I’m flying to Florida for Spring Break • I hire someone to paint my house… • …or fix my car • I ask you not to have a party on a particular night

This is what contracts are for • A contract is a promise… • …which is legally binding • Point of contracts: to enable trade when transactions aren’t concluded immediately

Example: the agency (trust) game Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (0, 200) • Subgame perfect equilibrium: I’ll keep all the money; so you don’t trust me • Inefficient outcome (100 < 200) • And we’re both worse off

(One solution: reputation)

Another solution: legally binding promises Player 1 (you) Trust me Don’t Player 2 (me) (100, 0) Share profits Keep all the money (150, 50) (125, 25) • Now we get cooperation (and efficiency) • Purpose of contract law: to allow trade in situations where this requires credible promises

Contract: a legally binding promise • Point of contracts: to enable trade when transactions aren’t concluded immediately • Obvious question: which promises should be legally binding, and which should not?

What types of promises should be enforced by the law? • “The rich uncle of a struggling college student learns at the graduation party that his nephew graduated with honors. Swept away by good feeling, the uncle promises the nephew a trip around the world. Later the uncle reneges on his promise. The student sues his uncle, asking the court to compel the uncle to pay for a trip around the world.” • “One neighbor offers to sell a used car to another for $1000. The buyer gives the money to the seller, and the seller gives the car keys to the buyer. To her great surprise, the buyer discovers that the keys fit the rusting Chevrolet in the back yard, not the shiny Cadillac in the driveway. The seller is equally surprised to learn that the buyer expected the Cadillac. The buyer asks the court to order the seller to turn over the Cadillac.” • “A farmer, in response to a magazine ad for “a sure means to kill grasshoppers,” mails $25 and receives in the mail two wooden blocks with the instructions, “Place grasshopper on Block A and smash with Block B.” The buyer asks the court to require the seller to return the $25 and pay $500 in punitive damages.”

The Bargain Theoryof Contracts

The bargain theory of contracts • Developed in the late 1800s/early 1900s • A promise should be enforced if it was given as part of a bargain, otherwise it should not • Bargains were taken to have three elements • Offer • Acceptance • Consideration

What is consideration? • Promisor: person who gives a promise • Promisee: person who receives it • In a bargain, both sides must give up something • reciprocal inducement • Consideration is what the promisee gives to the promisor, in exchange for the promise • Under the bargain theory, a contract becomes enforceable once consideration is given

The bargain theory does not distinguish between fair and unfair bargains • Hamer v Sidway (NY Appeals Ct, 1891) • Uncle offered nephew $5,000 to give up drinking and smoking until his 21st birthday, then refused to pay “The promisee [previously] used tobacco, occasionally drank liquor, and he had a legal right to do so. That right he abandoned for a period of years upon the strength of the promise… We need not speculate on the effort which may have been required to give up the use of these stimulants. It is sufficient that he restricted his lawful freedom of action within certain prescribed limits upon the faith of his uncle’s agreement, and now, having fully performed the conditions imposed, it is of no moment whether such performance actually proved a benefit to the promisor, and the court will not inquire into it.”

Under the bargain theory, what is the remedy? • Expectation damages • the amount of benefit the promisee could reasonably expect from performance of the promise • meant to make the promisee as well of as he would have been, if the promise had been fulfilled

So that’s one early theory • Not that accurate a description of what modern courts actually do • Not always efficient • Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable

So that’s one early theory • Not that accurate a description of what modern courts actually do • Not always efficient • Does not enforce certain promises that both promisor and promisee might have wanted to be enforceable • Does enforce certain promises that maybe should not be enforced

For efficiency, what promises should be enforced?

Econ 522 Economics of Law