Week 6

Property Rights
Institutional perspective
 Today, 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

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Foxes

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 One early, “classic” property law case

 Pierson v. Post (NY Supreme Court, 1805)

 Lodowick Post organized a fox hunt, was chasing
a fox
 Jesse Pierson appeared “out of nowhere,” killed
the fox and took it
 Post sued to get the fox back
 Lower court sided with Post; Pierson appealed
to the NY Supreme Court

 Question: when do you own an animal?

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 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

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 Same tradeoff we saw earlier:

Pierson gets the fox Post gets the fox

 simpler rule (finders  more efficient incentives

keepers)
 (stronger incentive to pursue
 easier to implement
animals that may be hard to
 fewer disputes 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
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 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
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 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

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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.

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 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
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 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!

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 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
 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 12
Bargaining

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Let’s go back to our
rancher and farmer

Do nothing:
$500 in crop
damage
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Let’s go back to our
rancher and farmer
Farmer builds
fence: $300

Rancher builds
fence: $400 15
 No fence: $500 in harm
Let’s go back to our Rancher builds fence: $400
Farmer builds fence: $300
rancher and farmer Law: Farmer’s Rights

 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? 16
 No fence: $500 in harm
Before bargaining: Rancher builds fence: $400
Farmer builds fence: $300
threat points Law: Farmer’s Rights

 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!

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 No fence: $500 in harm
Threat points Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights

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.

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 No fence: $500 in harm
Threat points Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights

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

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 No fence: $500 in harm
Gains from cooperation Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights

 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)

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 No fence: $500 in harm
So what will happen? Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights

 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

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 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 22
When are stronger property rights
“worth it”?

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 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…””
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Alchian, A. (1950): Uncertainty, Evolution,
and Economic Theory
What are the neoclassic assumptions which do not work?

 Complete information

 Perfect foresight

“Uncertainty arises from at least two sources: imperfect foresight and

human inability to solve complex problems containing a host of
variables even when an optimum is definable.” “Where foresight is
uncertain, ‘profit maximization’ is meaningless as a guide to
specifiable action.”

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Alchian, A. (1950): Uncertainty, Evolution,
and Economic Theory
Scarce resources –> Competing demands for the use of those
resources –> conflict of interest between interested parties –>
Resolution of conflict: by the market – through negotiation (or brute
force?..) by the allocation of property rights by a combination of the
two.

“Property rights are socially recognized rights to do things with a

scarce resource”.

What is owned are rights to use resources. It is not the resource

itself which is owned; it is a bundle, or a portion, of rights to use a
resource that is owned
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 Harold Demsetz (1967), “Toward a Theory of
Property Rights”

 Property rights are an instrument of society and derive their

significance from the fact that they help a man form those
expectations which he can reasonably hold in his dealings
with others.
 In the world of Robinson Crusoe property rights play no role

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 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.”
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 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
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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.
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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.

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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

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 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

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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.”

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 So…

 What are transaction costs, and how do we deal with them?

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Transaction
Costs

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 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

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 Bargaining costs come in many forms

 Asymmetric information
 Akerloff (1970), “The Market for Lemons” – adverse selection

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 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

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 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

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 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

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 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

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 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

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 So, what
do we do?
(won’t get to this)

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 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

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 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

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 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

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 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
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 So now we have one general principle we
can use for designing property law

 When transaction costs are low, design the law to

facilitate voluntary trade

 When transaction costs are high, design the law to

allocate rights efficiently whenever possible

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