Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2014 Lecture 5

2. Reminder • HW1 due online at noon tomorrow

3. Monday, we saw 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… • …provided there are no transaction costs • On the other hand, the initial allocation does affect distribution… • And if there are transaction costs, it can also affect efficiency

4. Foxes

5. One early, “classic” property law case • Pierson v. Post (NY Supreme Court, 1805) • Lodowick Post organized a fox hunt, was chasinga fox • Jesse Pierson appeared “out of nowhere,” killedthe fox and took it • Post sued to get the fox back • Lower court sided with Post; Pierson appealed to NY Supreme Court • Question: when do you own an animal? 4

6. One early, “classic” property law case • Court ruled for Pierson (the one who killed the fox) • “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” • (Also: just because an action is “uncourteous or unkind” does not make it illegal) • Dissenting opinion: a fox is a “wild and noxious beast,” and killing foxes is “meritorious and of public benefit” • Post should own the fox, in order to encourage fox hunting 5

7. Same tradeoff we saw earlier: Pierson gets the fox • simpler rule (finders keepers) • easier to implement • fewer disputes Post gets the fox • more efficient incentives • (stronger incentive to pursue animals that may be hard to catch) • Just like Fast Fish/Loose Fish vs Iron Holds The Whale • Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes • Iron Holds the Whale is more complicated, but is necessary with whales where hunting them the old-fashioned way is too dangerous 6

8. Doesn’t Coase make Pierson v Post irrelevant? • Coase seems to say: for efficiency, it doesn’t matter who starts off with the right to the fox • If Post values it more, he can buy it from Pierson, or vice versa • Seems to imply: one rule is just as good as the other, as long as we all know what the rule is • So why does Pierson v Post matter? • Transaction costs! • Majority: if Post gets the fox back, “it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly • Dissent: killing foxes is a good thing (externality), so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining

9. Transaction costs • Coase: “in the absence of transaction costs, if property rights are well-defined and tradable, 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

10. 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… 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.

11. 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 tradable, 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

12. Many externalities can be thought of as missing property rights • Overfishing in communal lake? • It’s because property rights over those fish aren’t well-defined • Firm polluting too much? • It’s because property rights over clean air aren’t well-defined • So one solution… • Make property rights complete enough to cover “everything,” and tradable, and use the law to minimize transaction costs… • …Then Coase kicks in and we get efficiency! (Booya!) • So why not do this? COSTS!

13. 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

14. 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

15. Bargaining

16. Let’s go back to ourrancher and farmer Do nothing: $500 in crop damage

17. Let’s go back to ourrancher and farmer Farmer builds fence: $300 Rancher builds fence: $400

18. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights Let’s go back to ourrancher and farmer • Three possibilities • Nobody builds a fence – $500 in damage • Rancher builds fence – $400 cost • Farmer builds fence – $300 cost • Suppose we’re in a farmer’s rights world • Rancher is liable for any damage done by his herd • What does Coase predict will happen? • They’ll bargain to efficient outcome • Meaning, the farmer will build a fence (and the rancher will pay him) • How much will he pay?

19. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights Before bargaining:threat points • Threat point – each party’s expected outcome if bargaining fails • “If we can’t agree to a deal and we go our separate ways, how well off am I?” • Also called outside option, or reservation utility • Deal has to make everyone better off than that!

20. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights Threat points What happens to me if I don’t reach a deal with the rancher? Well, he’s liable for any crop damage… …so there’s no reason for me to build a fence… …and if there’s any damage, he’ll have to reimburse me… …so if bargaining breaks down and I do nothing, my payoff is 0. That’s the best I can do on my own… …so that’s my threat point.

21. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights Threat points What happens if I don’t reach a deal with the farmer? He has no reason to build a fence… …and I’m liable for crop damage… …so my choices are to pay for $500 in damage… …or to build a $400 fence So clearly, I’ll build a fence So my payoff if we don’t make a deal is –$400 So that’s my threat point

22. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights Gains from cooperation • So under a closed-range law… • The farmer’s threat point is 0, the rancher’s is –$400 • Those are the payoffs that will happen if no agreement is reached • If a deal happens: total payoffs go up from –$400 to –$300 • Farmer will build a fence (efficient outcome), rancher will pay him some money • Cooperation causes total payoffs to go up by $100 • So $100 is gains from cooperation (or gains from trade)

23. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights So what will happen? • Coase predicts negotiation will lead to efficiency • So the gains from cooperation will be realized • (The farmer will build a fence) • Both sides have to do at least as well as their threat point • Otherwise, wouldn’t agree to deal • So rancher will pay farmer somewhere between $300 and $400 to build the fence • But what if we want a more precise prediction?

24. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights So what will happen? • What if gains from cooperation were split evenly? • Threat points 0 and –400, gains of 100 • Farmer’s payoff: 0 + ½ (100) = 50 • Rancher’s payoff: –400 + ½ (100) = –350 • How is this achieved? Rancher pays farmer $350 to build fence

25. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights If gains are split evenly… Farmer’s Rights Rancher’s Threat Point -400 Farmer’s Threat Point 0 Gains From Cooperation 100 Rancher’s Payoff (IF…) –400 + ½ (100) = –350 Farmer’s Payoff = 50 0 + ½ (100) Combined Payoffs -300

26. No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights If gains are split evenly… Rancher’s Rights Farmer’s Rights Rancher’s Threat Point 0 -400 Farmer’s Threat Point -300 0 Gains From Cooperation 0 100 Rancher’s Payoff (IF…) 0 -350 ¹ Farmer’s Payoff -300 50 Combined Payoffs -300 -300 =

27. One more example – you having a party next door to my house • Let’s suppose… • Having the party is worth $150 to you… • …and a good night’s sleep is worth $100 to me • So it’s efficient to have the party • If parties are allowed… • No need for negotiation • If parties are not allowed… • My threat point: 0 • Your threat point: 0 • Gains from cooperation: $50 • If split evenly: payoffs are $25 and $25 • Which requires you paying me $125 to have the party

28. When are stronger property rights “worth it”?

29. 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 from each other • Introduced a cost c of administering a property rights system 28

30. Private property leads to better use of resources, by eliminating externalities • Incentive to overuse communal resources • “Tragedy of the commons” – private property rights can fix this • Collective farming – incentive to shirk/freeride • Again, private property rights fix this – for example… • “It’s one of the ironies of American history that when the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death. • Fortunately… Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced. Bradford described the results… • “[Ending corn collectivism] had very good success, for it made all hands very industrious… The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability…”” - Marginal Revolution (blog post), “Thanksgiving Lessons”

31. 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.”

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

33. 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: moderate • 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

34. Friedman tells a similar story: “we owe civilization to the dogs” The date is 10,000 or 11,000 B.C. You are a member of a primitive tribe that farms its land in common. Farming land in common is a pain; you spend almost as much time watching each other and arguing about who is or is not doing his share as you do scratching the ground with pointed sticks and pulling weeds. …It has occurred to several of you that the problem would disappear if you converted the common land to private property. Each person would farm his own land; if your neighbor chose not to work very hard, it would be he and his children, not you and yours, that would go hungry.

35. Friedman tells a similar story: “we owe civilization to the dogs” There is a problem with this solution… Private property does not enforce itself. Someone has to make sure that the lazy neighbor doesn’t solve his food shortage at your expense. [Now] you will have to spend your nights making sure they are not working hard harvesting your fields. All things considered, you conclude that communal farming is the least bad solution.

36. Friedman tells a similar story: “we owe civilization to the dogs” Agricultural land continues to be treated as a commons for another thousand years, until somebody makes a radical technological innovation: the domestication of the dog. Dogs, being territorial animals, can be taught to identify their owner’s property as their territory and respond appropriately to trespassers. Now you can convert to private property in agricultural land and sleep soundly. Think of it as the bionic burglar alarm. -Friedman, Law’s Order, p. 118

37. So… • Coase: if property rights are complete and tradable, we’ll always get efficiency • can “fix” externalities by expanding property rights to cover • 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

38. Of course, Coase wasn’t actually ignoring costs… “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… 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.”

39. So… • What are transaction costs, and how do we deal with them?

40. TransactionCosts

41. 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

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

43. 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

44. 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

45. 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

46. 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

47. Example of high transaction costs when there are many sellers

48. 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

49. So, whatdo we do?(won’t get to this)

50. 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