Econ 522 Economics of Law

Dan Quint Spring 2011 Lecture 4

So far, we have…

 …defined some important tools
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defined efficiency, and gave reasons for why we might want the law to be designed to be efficient showed how externalities (among other things) lead to inefficiency introduced static games, the matrix representation of payoffs, and how to find equilibria

 …showed two ways in which a lack of clear property rights can lead to severe inefficiencies
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overfishing example farming/stealing game
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Once we have private property rights, we’ll have conflicts between mine and yours
 My neighbor likes tall trees

can he plant a tree on his property if it shades my pool, or blocks my view?

 You want to have a party

do you have the right to make noise in your house? or do I have the right to a good night’s sleep in my house?

 I own a small power plant located on a river
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do I have a right to use water from the river for cooling? do I have a right to pollute as much as I want?
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Up next: how should we design property rights to achieve efficiency?
 Cooter and Ulen: property is
“A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others”

 Doesn’t tell us how property law should be designed  Need to answer four fundamental questions:
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What things can be privately owned? What can (and can’t) an owner do with his property? How are property rights established? What remedies are given when property rights are violated?

Today: wild animals and Coase
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Foxes 4 .

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

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. “classic” property law case  Court ruled for Pierson (the one who killed the fox)   “If the first seeing.One early.” and killing foxes is “meritorious and of public benefit”  Post should own the fox. starting. or pursuing such animals… should afford the basis of actions against others for intercepting and killing them. in order to encourage fox hunting 6 .

but is necessary with whales where hunting them the old-fashioned way is too dangerous 7 . leads to fewer disputes Iron Holds the Whale is more complicated.Same tradeoff we saw earlier: Pierson gets the fox  Post gets the fox  simpler rule (finders keepers) easier to implement fewer disputes 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.

Coase 8 .

then voluntary negotiations will lead to efficiency   It doesn’t matter how rights are allocated initially… …because if they’re allocated inefficiently. under certain conditions. they can be sold/traded until they’re allocated efficiently 9 .How should property rights be allocated? Coase’s surprising answer: it doesn’t matter  More specifically. it doesn’t matter for efficiency  (Although it does matter for distribution)  Coase Theorem: in the absence of transaction costs. if property rights are well-defined and tradable.

Example of Coase: you have a car worth $3. I end up with it  efficient Regardless of who owns the car at first. 10  The key: lack of transaction costs .000 to me  Obviously. we get to the efficient outcome     I’d rather start out with the car – so I don’t have to pay you for it You’d rather start out with it – so you end up with more money Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. And that doesn’t depend on who starts with it. I end up with it  efficient If you start out owning the car: clear incentive for me to buy it.000 to you. $4. efficient for me to own it…  …but we don’t need the law to give me the car    If I start out owning the car: no reason for you to buy it.

no problem If you have right to party. I can pay you not to have it If it’s efficient to have the party. you don’t Regardless of who started off with the right  The point: either way. you can pay me for the right to have the party  If it’s efficient for you not to have the party…    Good night sleep is worth more to me If I have right to silence. no problem If I start out with the right to quiet. we achieve efficiency    11 .Another example: you want to have a party in the house next door to mine  If it’s efficient for you to have the party…    Your benefit from having the party is greater than my benefit from a good night’s sleep If you start out with the right to have the party. you have the party If it’s efficient not to.

The conditions for this to hold  Property rights have to be well-defined…  We need to be clear on who has what rights. so we know the starting point for negotiations  …and tradable…  We need to be allowed to sell/transfer/reallocate rights if we want  …and there can’t be transaction costs  It can’t be difficult or costly for us to buy/sell the right 12 .

“The Problem of Social Cost”  In the absence of transaction costs.The Coase Theorem  Ronald Coase (1960). voluntary negotiations will lead to efficiency. if property rights are well-defined and tradable.  So the initial allocation of rights doesn’t matter for efficiency  However. it does matter for distribution  And if there are transaction costs. it may matter for efficiency too 13 .

Coase’s example: a rancher and a farmer 14 .

Rancher’s versus farmer’s rights  English common law: “closed range” or “fencing-in” (or “farmer’s rights”)   Ranchers have responsibility to control their cattle Rancher must pay for any damage done by his herd  Much of the U.S. at various times: “open range” or “fencing-out” (or “rancher’s rights”)   Rancher can let his cattle roam free Not liable for damage they do to farmer’s crops (unless farmer had a good fence and they broke through anyway)  Which rule is more efficient? 15 .

Open range versus closed range 16 .

etc. crops.… …the rancher and farmer will negotiate to that efficient outcome. farmer can pay rancher to keep fewer cattle  Coase:    Whatever is the efficient combination of cattle. that’s what he’ll do Under closed range law. fences. regardless of which law is in place… …as long as the rights are well-defined and tradable and there are no transaction costs 17 . rancher can pay farmer to build fence  If smaller herd is more efficient.Coase: either law will lead to efficiency  If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd…   Under open range law.

live with damage… costs nothing  If expected crop damage = $100   Open range: farmer lives with damage rather than building fence Closed range: rancher pays for damage rather than fence  If expected crop damage = $500    Open range: farmer builds fence – efficient Coase: closed range: rancher pays farmer to build fence So efficient outcome under either rule 18 .Rancher and farmer: numerical example  Three possibilities:    Rancher builds fence around herd… costs $400 Farmer builds fence around crops… costs $200 Do nothing.

Other examples from Coase  Lots of examples from case law      a building that blocked air currents from turning a windmill a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door a doctor next door to a confectioner a chemical manufacturer a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller  In each case. regardless of who is initially held liable. the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation 19 .

The doctor’s work would not have been disturbed if the confectioner had not worked his machinery. but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place… 20 . In the case of the cattle and the crops. It is equally true that there would be no crop damage without the crops. 13): Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved.Quoting from Coase (p. it is true that there would be no crop damage without the cattle.

If we are to attain an optimum allocation of resources. both parties cause the damage. 13): If we are to discuss the problem in terms of causation. 21 . It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties.Quoting from Coase (p. it is therefore desirable that both parties should take the harmful effects into account when deciding on their course of action.

the farmer could ask the rancher for more than $200 to build the fence  “Opportunity cost” 22 .What does Coase mean by “a cost for both parties”?  If the cheapest alternative is for the farmer to build a fence for $200…   The cost to build a fence is $200 But the cost to not build a fence is more than $200 – since under a closed-range law.

voluntary negotiations will lead to efficiency.So. summing up…  Coase Theorem: In the absence of transaction costs. then the initial allocation can matter for efficiency… …and it will always matter for distribution) 23    .  The initial allocation of property rights therefore does not matter for achieving efficiency… …provided there are no transaction costs (But if there are transaction costs. if property rights are well-defined and tradeable.

Bargaining 24 .

000 to me Suppose I have $10. by refusing to cooperate with you also called reservation utility. and $4. 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 25 .000 to you.Some vocabulary about bargaining  Example from before:   Your car is worth $3.000 is my threat point   the payoff I can get on my own.000  $10.

000 if we cooperate.000  If I buy the car for some price P    my payoff is 4.000 + 10.000 (my threat point) your payoff is 3.000 combined payoffs are 13.000 – P your payoff is P combined payoffs are 14.000 are the gains from trade (or gains from cooperation)    no trade  combined payoffs of $13.000 26 .000  $1. our combined payoffs increase by $1.000 – P = 14.000 I buy car  combined payoffs of $14.Some vocabulary about bargaining  If I don’t buy the car from you…    my payoff is 10.000 – P + P = 14.

000  Gains from cooperation: 1.500  (Coase doesn’t specify gains will be divided equally.000 and 3. yours 3.500.000  Suppose the gains from cooperation were split equally    we’d each get 500 more than threat point my payoff would be 10.Some vocabulary about bargaining  Threat points: 10. just that they’ll be divided in some way) 27 .500 which means P = $3.

fence around crops costs $200 Rancher’s Rights Farmer’s Rights Rancher’s Threat Point Farmer’s Threat Point Gains From Cooperation Rancher’s Payoff (IF…) Farmer’s Payoff Combined Payoffs 0 -200 0 0 -200 -200 -400 0 200  = -300 100 -200 28 . fence around herd costs $400.Let’s go back to the rancher and farmer  Cows do $500 damage.

firms maximize profits prices are such that all markets clear  First Welfare Theorem: general equilibrium is efficient  But not when there are externalities.Relating Coase to general equilibrium/ first welfare theorem  General equilibrium    given prices. or “missing markets”  Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights 29 . consumers maximize utility given prices.

consumers maximize utility given prices. or “missing markets”  Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rights 30 .Relating Coase to general equilibrium/ first welfare theorem  General equilibrium    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.

Getting back to foxes… 31 .

“it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly Dissent: killing foxes is a good thing (externality).Doesn’t Coase make Pierson v Post irrelevant?  Coase seems to say: for efficiency. 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. so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining 32 . it doesn’t matter who starts off with the right to the fox   If Post values it more. he can buy it from Pierson.

voluntary negotiations will lead to efficiency. if property rights are well-defined and tradable. voluntary negotiations may not lead to efficiency  Car example (yet again)   If transactions are costly. we incur that cost 33 .Transaction costs  Coase: “in the absence of transaction costs.”  This suggests that if there are transaction costs. we may not trade And if we do trade.

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.Quoting Coase… “If market transactions were costless. In such cases. 34 . 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. it is obviously desirable to reduce the need for such transactions and thus reduce the employment of resources in carrying them out. the courts directly influence economic activity. …Even when it is possible to change the legal delimitation of rights through market transactions.

”  We can read this as…   “As long as transaction costs aren’t a big deal.We can see the Coase Theorem as either a positive or negative result  “In the absence of transaction costs. voluntary negotiations will lead to efficiency. “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 35 . we’ll get efficiency” Or as. if property rights are well-defined and tradable.

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! 36 .

Demsetz 37 .

We motivated property law by looking at a game between two neighboring farmers ORIGINAL GAME Player 2 Farm Player 1 Farm 10. 12 – P Steal 12 – P. -P  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 38 . -5 – c Steal 12. 0 -P. 12 Farm MODIFIED GAME Player 2 Steal Farm 10 – c. 10 – c -5 – c. 10 Steal Player 1 -5. -5 0.

” 39 . “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.Harold Demsetz (1967).”  “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.

so gains from internalization were small gains < costs  no private ownership of land 40 .”  Private ownership of land among Native Americans   Cost of administering private ownership: moderate Before fur trade…   externality was small. “Toward a Theory of Property Rights”  “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.Harold Demsetz (1967).

”  Private ownership of land among Native Americans   Cost of administering private ownership: moderate Before fur trade…   externality was small. so gains from internalization grew gains > costs  private property rights developed 41  As fur trading developed…   .Harold Demsetz (1967). so gains from internalization were small gains < costs  no private ownership of land externality grew. “Toward a Theory of Property Rights”  “Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.

Each person would farm his own land. You are a member of a primitive tribe that farms its land in common.C.000 B. 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.Friedman tells a similar story: “we owe civilization to the dogs” The date is 10. not you and yours. 42 . Farming land in common is a pain. it would be he and his children. …It has occurred to several of you that the problem would disappear if you converted the common land to private property.000 or 11. that would go hungry. if your neighbor chose not to work very hard.

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. 43 .Friedman tells a similar story: “we owe civilization to the dogs” There is a problem with this solution… Private property does not enforce itself. you conclude that communal farming is the least bad solution.

p.Friedman tells a similar story: “we owe civilization to the dogs” Agricultural land continues to be treated as a commons for another thousand years. being territorial animals. Now you can convert to private property in agricultural land and sleep soundly. Think of it as the bionic burglar alarm. Dogs. until somebody makes a radical technological innovation: the domestication of the dog. 118 44 . -Friedman. Law’s Order. can be taught to identify their owner’s property as their territory and respond appropriately to trespassers.

Coase wasn’t completely ignoring costs…  Next week: what are transaction costs. 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.So…  Coase: if property rights are complete and tradeable. how do we deal with them? 45 . we’ll always get efficiency  Demsetz:     yes.