Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2014 Lecture 7

Monday, we “tested the Coase Theorem” • Can UW undergrads reallocate poker chips efficiently? • (Cost me $161 to find out) • What happened?

Our experiment… • Take 1: Full Information (values on nametags) startingallocation efficientallocation actual final allocation fraction of potential gains realized purple chip 12 red chip 10 purple chip red chip 10 purple chip purple chip 8 red chip purple chip purple chip 8 purple chip purple chip 6 purple chip 6 4 purple chip 4 purple chip 2 purple chip 32 60 58 26/28 = 93%

Our experiment… • Take 2: Private Information (values hidden) startingallocation efficientallocation actual final allocation fraction of potential gains realized 10 red chip purple chip red chip 8 purple chip 8 purple chip purple chip purple chip 6 red chip purple chip purple chip 6 purple chip 4 purple chip 4 3 purple chip 3 purple chip 2 purple chip 24 48 46 22/24 = 92%

Our experiment… • Take 3: Uncertainty • All three chips got sold, at prices around $8 • Rolls were 1, 3, and 6, so one buyer lost money… • …but trade was still efficient • And we achieved 100% of gains from trade • Take 4: Asymmetric Information • Rolled 3, 3, and 6 • One of the 3s got traded, for $6 • So we achieved 3/(3+3+6) = 25% of gains from trade

Conclusion • Coase seems to work pretty well, except when there’s asymmetric information/adverse selection • Full info: 93% of gains achieved • Private info: 92% of gains • Uncertainty: 100% • Asymmetric info: 25%

Example of Coasian bargaining I found last semester source: http://www.thestar.com/yourtoronto/education/2013/09/19/u_of_t_students_trade_cash_for_seats_in_full_classes.html#sthash.ukMK1JYp.dpuf

One other observation: information can be bad for the person who has it • Consider a seller in the last two cases • Your value = 2 x die roll, EV = $7.00 • If you know nothing… • Trade at some price between $7 and $10.50 • Expected payoff might be $8 • If you know value exactly… • Asymmetric information might mean you can’t trade at all • So expected payoff would be $7 • So expected payoff is higher if you don’t have information, or the value of the information is negative!

Back toproperty law…

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?

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? 10

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) 11

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 12

Comparing property/injunctive relief to liability/damages rule • Injuree (person whose entitlement is violated) always prefers a property rule • Injurer always prefers a damages rule • Why? • Punishment for violating a property rule 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 may have to pay more 13

Comparing injunctive relief todamages – example E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 • Electric company E emits smoke, dirties the laundry at a laundromat L next door • E earns profits of 1,000 • Without smoke, L earns profits 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 14

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 15

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 16

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 17

Comparing injunctions to damages… • Injunctions are generally cheaper to administer • No need for court to calculate amount of harm done 18

Comparing injunctions to damages… • Injunctions are generally cheaper to administer • No need for court to calculate amount of harm done • Damages are generally more efficient when private bargaining is impossible • 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 19

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 20

Exactly agrees with our earlier principle • 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 right to violate entitlement when efficient, even without prior consent 21

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) 22

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) 23

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.” 24

So, do we buy it? • Coase relies on parties being able to negotiate privately if the right is not assigned efficiently • Low-TC case: injunctions more efficient, assuming bargaining works if “wrong” party is awarded the right • But does it work? • Paper by Farnsworth shows no bargaining after 20 nuisance cases • Our experiment showed various transaction costs that asymmetric information can be an impediment to trade 25

Third way to protect an entitlement: inalienability • Inalienability: when an entitlement is not transferable or saleable • Allocative externalities(enriched uranium) 26

Third way to protect an entitlement: inalienability • Inalienability: when an entitlement is not transferable or saleable • Allocative externalities(enriched uranium) • “Indirect” externalities(human organs) 27

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/ 28

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

Our conclusions (from Calabresi/Melamed) • 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 textbook • TC low: design law to facilitate trade (normative Coase) • TC high: design law to not rely on bargaining (normative Hobbes) 30

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?

Public versus Private Goods Private Goods • rivalrous – one’s consumption precludes another • excludable – technologically possible to prevent consumption • example: apple Public Goods • non-rivalrous • non-excludable • examples • defense against nuclear attack • infrastructure (roads, bridges) • parks, clean air, large fireworks displays

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited • When public goods are privately owned, they tend to be underprovided/undersupplied

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited • When public goods are privately owned, they tend to be underprovided/undersupplied • Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated

This accords with the principle from Monday • Transaction costs low facilitate voluntary trade • Private goods – low transaction costs • Private ownership facilitates trade • Transaction costs high  allocate rights efficiently • Public goods – high transaction costs • Public provision/regulation required to get efficient amount

A different view: transaction costs • Clean air • Large number of people affected  transaction costs high  injunctive relief unlikely to work well • Still two options • One: give property owners right to clean air, protected by damages • Two: public regulation • Argue for one or the other by comparing costs of each • Damages: costs are legal cost of lawsuits or pretrial negotiations • Regulation: administrative costs, error costs if level is not chosen correctly 38

How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

What can an owner do with his property? • For efficiency: principle of maximum liberty • Owners can do whatever they like with their property… • …provided that doesn’t interfere with others’ property or rights • That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else • Textbook: common law often approximates rule of maximum liberty • Does it really? What about bans on repugnant markets? And…

“Maximum liberty” vs. government’s right to regulate • Ruling two years ago by a Dane County judge • Plaintiffs argued they had a “fundamental right to own a cow, and to use their cows in a manner that does not cause harm to a third party” • Judge responded: “Plaintiffs do not have a fundamental right to own and use a dairy cow or a dairy herd Plaintiffs do not have a fundamental right to consume the milk from their own cow Plaintiffs do not have a fundamental right to board their cow at the farm of a farmer The private contract does not fall outside the scope of the States’ police power Plaintiffs do not have a fundamental right to produce and consume the foods of their choice DATCP has jurisdiction to regulate the Plaintiffs’ conduct”

How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

Fugitive property • Hammonds v. Central Kentucky Natural Gas Co. • Central Kentucky leased land lying above natural gas deposits • Geological dome lay partly under Hammonds’ land • Central Kentucky drilled down and extracted the gas • Hammonds sued, claiming some of the gas was his • (Anybody see “There Will Be Blood”?) Hammonds Central KY

Two principles for establishing ownership • First Possession • nobody owns fugitive property until someone possesses it • first to “capture” a resource owns it • Central Kentucky would own all the gas • Tied Ownership • ownership of fugitive property tied to something else (here, surface) • so ownership already determined before resource is extracted • Hammonds would own some of the gas, since under his land • principle of accession – a new thing is owned by the owner of the proximate or prominent property

First Possession versus Tied Ownership • First Possession • simpler to apply – easy to determine who possessed property first • incentive to invest too much to early in order to establish ownership • example: $100 of gas, two companies drilling fast or slow • drilling slowly costs $5, drilling fast costs $25 • drill same speed  each gets half the gas, one drills fast  75/25 Firm 2 Slow Fast 45, 45 20, 50 Slow Firm 1 50, 20 25, 25 Fast

First Possession versus Tied Ownership • First Possession • simpler to apply – easy to determine who possessed property first • incentive to invest too much to early in order to establish ownership • Tied Ownership • encourages efficient use of the resource • but, difficulty of establishing and verifying ownership rights Firm 2 Slow Fast 45, 45 45, 25 Slow Firm 1 25, 45 25, 25 Fast

This brings us to the following tradeoff: Rules that link ownership to possession have the advantage of being easy to administer, and the disadvantage of providing incentives for uneconomic investment in possessory acts. Rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer.

We’ve already seen two examples of this • “Fast fish/loose fish” and “the guy who kills a fox, owns it” are examples of a first possession rule • You can’t own a resource until you physically possess it • “Iron holds the whale” and “the guy chasing a fox owns it” are examples of a tied ownership rule • You can establish ownership of something before you actually possess it • (A harpoon, or chasing a fox, gives you a right to it) • More complicated/costly to enforce • “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” • But avoids incentive to poach someone else’s resource

Another nice historical example: the Homestead Act of 1862 • Meant to encourage settlement of the Western U.S. • Citizens could acquire 160 acres of land for free, provided • head of a family or 21 years old • “for the purpose of actual cultivation, and not… for the use or benefit of someone else” • had to live on the claim for 6 months and make “suitable” improvements • Basically a first possession rule for land – by living on the land, you gained ownership of it • Friedman: caused people to spend inefficiently much to gain ownership of the land

Econ 522 Economics of Law