Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Fall 2009 Lecture 4

2. Outline • Last lecture, we… • introduced static games, the matrix representation of payoffs, and how to find equilibria • motivated the need for property law (“anarchy is inefficient”) • introduced the Coase Theorem • Today… • more on Coase • what are transaction costs, and what happens when they are present? • Demsetz on when (and why) property rights develop

3. Coase

4. From last week: 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… • …although it does matter for distribution… • …and it may matter for efficiency if there are transaction costs

5. Example: rancher and farmer • Three possibilities: • Rancher builds fence around herd… $400 • Farmer builds fence around crops… $200 • Do nothing, live with damage • If expected damage = $100… • If expected damage = $500… • Coase: “One of the beauties of a smoothly operating pricing system… the fall in the value of production due to the harmful effect would be a cost for both parties.”

6. Some vocabulary about bargaining • Example from before: • Your car is worth $3,000 to you, and $4,000 to me; 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

7. Some vocabulary about bargaining • Suppose 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 • 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 • If gains from trade were divided equally… • we’d each get 500 more than threat point • my payoff is 10,500, yours is 3,500, which means P = $3,500 • (Coase doesn’t say gains will be divided equally)

8. Let’s go back to the rancher and farmer • Cows do $500 damage; fence around herd costs $400; fence around crops costs $200 Rancher’s Rights Farmer’s Rights Rancher’s Threat Point 0 -400 Farmer’s Threat Point -200 0 Gains From Trade 0 200 Rancher’s Payoff (IF…) 0 -300 Farmer’s Payoff -200 100 Combined Payoffs -200 -200

9. 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

11. Demsetz

12. 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 Steal Steal • Changing the game had two effects: • Allowed us to “cooperate” by not stealing • Introduced a cost c of administering a property rights system 11

13. 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.”

14. 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: medium • Before fur trade… • externality was small, so gains from internalization were small • gains < costs  no private ownership of land

15. 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: medium • 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

16. So… • Coase: if property rights are complete and tradeable, we’ll 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 wasn’t completely ignoring costs…

17. Transaction Costs

18. So… • Coase: “in the absence of transaction costs, if property rights are well-defined and tradeable, 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

19. 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 as we have seen, 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.

20. 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 tradeable, 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

21. What Are Transaction Costs?

22. 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

23. Bargaining costs come in many forms • Asymmetric information • Akerloff (1970), “The Market for Lemons” – adverse selection

24. Bargaining costs come in many forms • 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

25. Bargaining costs come in many forms • 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

26. Bargaining costs come in many forms • Large numbers of parties • Developer values large area of land at $1,000,000 • 10 homeowners, each value their plot at $80,000

27. Bargaining costs come in many forms • 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

28. 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

29. So, what do we do?

30. 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

31. 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

32. 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

33. 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

34. Coming up… • Tuesday: how should property rights be enforced? • Calabresi and Melamed, Property Rights, Liability Rules, and Inalienability: One View of the Cathedral • No lecture on Thursday October 1 • First HW will be posted soon, due Tuesday October 6 • First midterm Tuesday October 13, on property law