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PROPERTY RIGHTS AND CONTRACTS October 10, 2006

PROPERTY RIGHTS AND CONTRACTS October 10, 2006. PROPERTY RIGHTS AND CONTRACTS October 10, 2006. Coase Theorem Exceptions To Coase Theorem Transaction Costs - October 17, 2006 Asymmetric Information - October 24, 2006 Empty Core - October 31, 2006.

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PROPERTY RIGHTS AND CONTRACTS October 10, 2006

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  1. PROPERTY RIGHTS AND CONTRACTS October 10, 2006

  2. PROPERTY RIGHTS AND CONTRACTSOctober 10, 2006 • Coase Theorem • Exceptions To Coase Theorem • Transaction Costs - October 17, 2006 • Asymmetric Information - October 24, 2006 • Empty Core - October 31, 2006

  3. CONTRACTS – Terms And ConditionsOctober 10, 2006 • COLOUR CODE FOR GRAPHS • Marginal Cost Curve for Agent (firm, individual) under a strict liability rule • Marginal Cost Curve for Agent (firm, individual) under a no liability rule • Marginal Cost Curve for Agent (firm, individual) under a negotiated contract that follows the Theoem of Coase • Demand Curve for the Agent’s output • Marginal Revenue Curve

  4. CONTRACTS – Terms And ConditionsOctober 10, 2006 • COLOUR CODE FOR GRAPHS (con’t) • Average Cost Curve for Agent (firm, individual) with no transaction costs • Average Cost Curve for Agent (firm, individual) with transaction costs • Profit of Agent (firm, individual) • Portion of profit traded in exchange for property rights • Portion of profit lost due to a trade in property rights • Portion of profit lost due to transaction costs

  5. PROPERTY RIGHTSContracting Property Rights • Recall that in the McKie v. KVP case, Justice McRuer J. dismissed the “Crown lease” argument raised by KVP on the grounds that any contract permitting harm to the Plaintiffs' property must be done by way of an express contract among all the parties.

  6. PROPERTY RIGHTSContracting Property Rights In making this finding, McCruer was unintentionally raising a central point in the economic analysis of property rights – that it might be conceivably be possible that, for a payment, a party might agree by contract to allow another party to inflict harm on it.

  7. PROPERTY RIGHTSContracting Property Rights What kind of a contract was McRuer J. imagining here?

  8. PROPERTY RIGHTSContracting Property Rights Recall the “nuisance problem” discussed in the third lecture dated September 26, 2006?

  9. PROPERTY RIGHTSContracting Property Rights • Agents operate two firms: a1 = output of Agent 1 a2 = output of Agent 2

  10. PROPERTY RIGHTSContracting Property Rights • The profit function of Agent 1 is: p1 = pa1 – C(a1) • The pollution function of Agent 1 is: D(a1) = (a1)^2

  11. Perfectly Competitive-Agent 1 Market – Agent 1 PROPERTY RIGHTSContracting Property Rights P D S S MC SATC a1

  12. PROPERTY RIGHTSContracting Property Rights • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 P D LATC S = MC1 LATC S MC1 SATC SATC PM PPC a1

  13. PROPERTY RIGHTSContracting Property Rights • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 P D LATC LATC S MC1 PM PPC a1

  14. PROPERTY RIGHTSContracting Property Rights Recall that the output of Agent 1 is jointly produced with pollution which imposes damages on Agent 2 according to the damage function D(a1) = (a1)^2

  15. PROPERTY RIGHTSContracting Property Rights • Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2 P No negative externality D LATC LATC S MC1 PM PM PPC Negative externality a1

  16. PROPERTY RIGHTSStrict Liability Rule Agent 1 creates a harmful nuisance that hurts Agent 2 economically. . Agent 2 has the exclusive use to its property rights

  17. PROPERTY RIGHTSStrict Liability Rule • Recall that Agent 2’s property rights include the right to sue Agent 1 • Furthermore, if Agent 1 “knows” this, it will produce the socially optimal level of output and pollution

  18. PROPERTY RIGHTSStrict Liability Rule • The profit function of Agent 1 under the strict liability rule becomes: p1 = pa1 – C(a1) - (a1)^2 p1 = 25/16

  19. PROPERTY RIGHTSStrict Liability Rule • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 No Liability P D LATC LATC S MC1 PM PPC Strict Liability Rule a1

  20. PROPERTY RIGHTSStrict Liability Rule • So Agent 1 takes into account the ability of Agent 2 to sue it when it maximizes its profits: Output = (a1)* = 5/8 Pollution = (a1)^2* = 25/64

  21. PROPERTY RIGHTSStrict Liability Rule • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 P D LATC LATC S MC1 MC1 PM PPC Strict Liability Rule a1

  22. PROPERTY RIGHTSStrict Liability Rule • Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2 P Strict Liability Rule D LATC LATC S MC2 MC2 PM PPC a1

  23. PROPERTY RIGHTSNo Liability Rule Agent 1 creates a harmful nuisance that hurts Agent 2 economically. . Agent 2 loses the exclusive use to its property rights to protect it against pollution

  24. PROPERTY RIGHTSNo Liability Rule • The profit function of Agent 1 under the no liability rule becomes: p1 = pa1 – C(a1) p1 = 25/12 > 25/16

  25. PROPERTY RIGHTSNo Liability Rule • So Agent 1 does not take into account the possibility of Agent 2 to sue it when it maximizes its profits: Output = (a1)** = 5/6 > 5/8 Pollution = (a1)^2** = 25/36 > 25/64

  26. PROPERTY RIGHTSNo Liability Rule • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 No Liability P D LATC LATC S MC1 MC1 PM PPC a1

  27. PROPERTY RIGHTSNo Liability Rule • Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2 P D LATC MC2 LATC S MC2 P’M PM PPC No Liability Rule a1

  28. NEGOTIATION PROPERTY RIGHTSContracting Property Rights

  29. PROPERTY RIGHTSCollusion • Could Agent 1 and Agent 2 collude to maximize social surplus, thereby increasing individual profits?

  30. PROPERTY RIGHTSCollusion – No Liability Rule Applies Agent 1 creates a harmful nuisance that hurts Agent 2 economically. . Agent 2 has lost the exclusive use to its property rights to protect it against pollution

  31. PROPERTY RIGHTSCollusion – No Liability Rule Applies • Although Agent 1 can produce more and Agent 2 will produce less under the no liability law, Agent 1 might be persuaded to also produce less in exchange for a transfer payment that might allow Agent 2 to produce more

  32. PROPERTY RIGHTSCollusion – No Liability Rule Applies The legal problem of nuisance now becomes a contract problem: Agent 2 wishes to make a payment to Agent 1 (a bribe) to induce Agent 1 to reduce its output from the market or private efficiency level of aP1 = 5/6. What bribe is Agent 2 willing to pay for a given level of output aC1 < aP1 = 5/6?

  33. PROPERTY RIGHTSCollusion – No Liability Rule Applies Agent 1 sets its production at a new “contracted” level, which is still socially sub-optimal, but it takes into account both the payment and the pollution: MAX [pa1 – C(a1) + PAYMENT - D(a1)] = MAX [5a1 – 3a1^2 + PAYMENT]

  34. PROPERTY RIGHTSCollusion – No Liability Rule Applies LEGAL ANALYSIS PROMISED ECONOMIC ANALYSIS Principal PAYMENT Agent PARTICIPATION CONSTRAINT Agent PROMISED PERFORMANCE INCENTIVE COMPATIBILITY CONSTRAINT

  35. PROPERTY RIGHTSCollusion – No Liability Rule Applies So the participation constraint for the bribe payment offered to Agent 1 by Agent 2: pC1 = p(aC1) + BRIBE> 25/12 Why? Because under no contract, Agent 1 can at the very least earn p1 = 25/12

  36. PROPERTY RIGHTSCollusion – No Liability Rule Applies Damages suffered by Agent 2 without the payment to Agent 1 would be: D(aP1) = 25/36 Minimum damages suffered by Agent 2 under the strict liability “ideal” would be: D(aSO1) = 25/64

  37. PROPERTY RIGHTSCollusion – No Liability Rule Applies Damages suffered by Agent 2 without the payment to Agent 1 would be: D(aP1) = 25/36 However, if the ideal of “zero-pollution” operates for Agent 2 : D(aO1) = 0 Maximum Payment From Agent 2 25/36

  38. PROPERTY RIGHTSCollusion – No Liability Rule Applies Profit earned by Agent 1 without the payment to Agent 1 would be: p1(aP1) = 25/12 Profit earned by Agent 1 under the strict liability “rule” would be: p1(aSO1) = 25/16 Minimum Payment to Agent 1 25/48

  39. The “optimal” bribe or transfer payment lies within the interval: 25/48 <PAYMENT< 25/36 This interval is called the “core” of the contract, since any point in the interval would be a Nash equilibrium PROPERTY RIGHTSCollusion – No Liability Rule Applies

  40. PROPERTY RIGHTSCollusion – No Liability Rule Applies The incentive compatibility constraint for Agent 1 promising to cut back pollution: p(aP1) < p(aC1) + PAYMENT where aC1 is the “contracted” level of output

  41. PROPERTY RIGHTSCollusion – No Liability Rule Applies The “core” of the contract represents the intersection set of feasible or possible contract points that satisfy (i) the participation constraint of the polluter (Agent 1) (ii) the incentive compatibility constraint of the polluter (Agent 2)

  42. PROPERTY RIGHTSCollusion – No Liability Rule Applies Note that if it costs Agent 1 more than 25/36 in transaction costs to enter the contract with Agent 2, then the contract will not happen T< 25/36

  43. PROPERTY RIGHTSCollusion – No Liability Rule Applies PRINCIPAL Agent 2 Offers a Bribe or a Transfer Payment To Agent 1 promise payment AGENT Agent 1 promises to cutback production or incur the expense of pollution abatement

  44. PROPERTY RIGHTSCollusion – No Liability Rule Applies • Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1 No Liability P D LATC LATC S MC1 MC1 PM PPC a1

  45. PROPERTY RIGHTSCollusion – No Liability Rule Applies • Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2 P D LATC MC2 LATC S MC2 P’M PM PPC No Liability Rule a1

  46. PROPERTY RIGHTSCollusion – Strict Liability Rule Applies Agent 1 creates a harmful nuisance that hurts Agent 2 economically. . Agent 2 has the exclusive use to its property rights to protect it against pollution

  47. PROPERTY RIGHTSCollusion – Strict Liability Rule Applies • Although Agent 2 can produce more and Agent 1 will produce less under the strict liability rule, Agent 2 might be persuaded to also produce less in exchange for a transfer payment that might allow Agent 1 to produce more

  48. PROPERTY RIGHTSCollusion – Strict Liability Rule Applies The Legal problem of nuisance again becomes a Contract problem: Agent 1 wishes to make a payment to Agent 2 (a bribe) to induce Agent 2 to allow its output to be reduced from the legally protected level. What bribe is Agent 1 willing to pay for a given level of output aC1 > aSO1

  49. PROPERTY RIGHTSCollusion – Strict Liability Rule Applies Agent 2 wants minimal pollution, but it takes into account both the payment and the pollution: MAX [PAYMENT - D(a1)]

  50. PROPERTY RIGHTSCollusion – Strict Liability Rule Applies LEGAL ANALYSIS PROMISED ECONOMIC ANALYSIS Principal PAYMENT Agent PARTICIPATION CONSTRAINT Agent PROMISED PERFORMANCE INCENTIVE COMPATIBILITY CONSTRAINT

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