Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2013 Lecture 5

Reminder • HW1 due online at 11:59 p.m. Thursday

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

At the end, we related this to General Equilibrium and the First Welfare Theorem • GE: consumers and firms take prices as given, optimize consumption/production; prices are such that markets clear • First Welfare Theorem: general equilibrium is efficient • Breaks down when there are externalities, or “missing markets” • Something in peoples’ utility functions that they can’t demand • So one way to fix externalities is to “make markets more complete” • Same as Coase – once we allow trade in something, it should get allocated efficiently

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!

Today • When will it be worth it to expand property rights to correct an externality problem? • What do we do when there are transaction costs, so efficiency is not guaranteed?

When are stronger property rights “worth it”?

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 7

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”

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.”

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

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

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.

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.

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

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

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.”

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

TransactionCosts

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

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

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

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

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

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

Example of high transaction costs when there are many sellers

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

So, whatdo we do?

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

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

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

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

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

Designing an efficient property law system

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 a principle we just saw • 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 of public goods required to get efficient amount

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?

we’ll probably end here – for Monday, read Calabresi and Melamed

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?

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)

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

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

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 Comparing injunctive relief todamages – example • 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

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 First, we consider thenon-cooperative outcomes • 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

Econ 522 Economics of Law