coase THEOREMA

8/12/2019 coase THEOREMA

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Econ 522Economics of Law

Dan Quint

Spring 2011Lecture 4



1

…defined some important tools 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, andhow to find equilibria

…showed two ways in which a lack of clear property rightscan lead to severe inefficiencies overfishing example

farming/stealing game

So far, we have…



2

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 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?

Once we have private property rights, we’llhave conflicts between mine and yours



33

Cooter and Ulen: property is

“A bundle of legal rights over resources that the owner is free toexercise 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: 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

Up next: how should we design propertyrights to achieve efficiency?



4

Foxes



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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 appealedto NY Supreme Court

Question: when do you own an animal?

One early, “classic” property law case



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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,” andkilling foxes is “meritorious and of public benefit” Post should own the fox, in order to encourage fox hunting

One early, “classic” property law case



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Pierson gets the fox

simpler rule (finders

keepers)

easier to implement

fewer disputes

Same tradeoff we saw earlier:

Post gets the fox

more efficient incentives

(stronger incentive to pursueanimals that may be hard tocatch)

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 withwhales where hunting them the old-fashioned way is too dangerous



8

Coase



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More specifically, under certain conditions, it doesn’t matterfor efficiency (Although it does matter for distribution)

Coase Theorem: in the absence of transaction costs, ifproperty rights are well-defined and tradable, thenvoluntary negotiations will lead to efficiency

It doesn’t matter how rights are allocated initially…

…because if they’re allocated inefficiently, they can be sold/tradeduntil they’re allocated efficiently

How should property rights be allocated?Coase’s surprising answer: it doesn’t matter



10

Obviously, 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, I end up with it efficient

If you start out owning the car:

clear incentive for me to buy it, I end up with it efficient

Regardless of who owns the car at first, we get to the efficientoutcome

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 eachend up with – just who ends up with the car at the end.

And that doesn’t depend on who starts with it.

The key: lack of transaction costs

Example of Coase: you have a car worth$3,000 to you, $4,000 to me



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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, no problem

If I start out with the right to quiet, you can pay me for the right tohave 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 you have right to party, I can pay you not to have it

The point: either way, we achieve efficiency If it’s efficient to have the party, you have the party

If it’s efficient not to, you don’t

Regardless of who started off with the right

Another example: you want to have a partyin the house next door to mine



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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

The conditions for this to hold



13

Ronald Coase (1960), “The Problem of Social Cost”

In the absence of transaction costs,

if property rights are well-definedand tradable, voluntary negotiationswill lead to efficiency. 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

The Coase Theorem



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Coase’s example: a rancher and a farmer



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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?

Rancher’s versus farmer’s rights



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Open range versus closed range



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If it’s cheaper for the farmer to protect his crops than for therancher to control his herd… Under open range law, that’s what he’ll do

Under closed range law, rancher can pay farmer to build fence

If smaller herd is more efficient, farmer can pay rancher tokeep fewer cattle

Coase: Whatever is the efficient combination of cattle, crops, fences, etc.…

…the rancher and farmer will negotiate to that efficient outcome,regardless of which law is in place…

…as long as the rights are well-defined and tradable and there are

no transaction costs

Coase: either law will lead to efficiency



18

Three possibilities: Rancher builds fence around herd… costs $400

Farmer builds fence around crops… costs $200

Do nothing, 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

Rancher and farmer: numerical example



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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, theparties can negotiate with each other and take whichever

remedy is cheapest to fix (or endure) the situation

Other examples from Coase



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Judges have to decide on legal liability but this should notconfuse economists about the nature of the economicproblem involved.

In the case of the cattle and the crops, it is true that therewould be no crop damage without the cattle. It is equallytrue that there would be no crop damage without the crops.

The doctor’s work would not have been disturbed if theconfectioner had not worked his machinery; but themachinery would have disturbed no one if the doctor hadnot set up his consulting room in that particular place…

Quoting from Coase (p. 13):



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If we are to discuss the problem in terms of causation, bothparties cause the damage.

If we are to attain an optimum allocation of resources, it istherefore desirable that both parties should take theharmful effects into account when deciding on their courseof action.

It is one of the beauties of a smoothly operating pricingsystem that… the fall in the value of production due to theharmful effect would be a cost for both parties.

Quoting from Coase (p. 13):



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If the cheapest alternative is for the farmer to build a fencefor $200… The cost to build a fence is $200

But the cost to not build a fence is more than $200 – since under aclosed-range law, the farmer could ask the rancher for more than$200 to build the fence

“Opportunity cost”

What does Coase mean by “a cost for bothparties”?



23

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

(But if there are transaction costs, then the initial allocation canmatter for efficiency…

…and it will always matter for distribution)

So, summing up…



24

Bargaining



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Example from before: Your car is worth $3,000 to you, and $4,000 to me

Suppose I have $10,000

$10,000 is my threat point

the payoff I can get on my own, by refusing to cooperate with you

also called reservation utility, or outside option

$3,000 is your threat point

Any outcome we both agree to must make us both at leastas well-off as our threat point

Some vocabulary about bargaining



26

If I don’t buy the car from you… my payoff is 10,000 (my threat point)

your payoff is 3,000

combined payoffs are 13,000

If I buy the car for some price P my payoff is 4,000 + 10,000 – P = 14,000 – P

your payoff is P

combined payoffs are 14,000 – P + P = 14,000

$1,000 are the gains from trade (or gains from cooperation) no trade combined payoffs of $13,000

I buy car combined payoffs of $14,000

if we cooperate, our combined payoffs increase by $1,000




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Threat points: 10,000 and 3,000

Gains from cooperation: 1,000

Suppose the gains from cooperation were split equally we’d each get 500 more than threat point

my payoff would be 10,500, yours 3,500 which means P = $3,500

(Coase doesn’t specify gains will be divided equally, just

that they’ll be divided in some way)




28

Cows do $500 damage; fence around herd costs $400;fence around crops costs $200

Let’s go back to the rancher and farmer

-200-200Combined Payoffs

100-200Farmer’s Payoff

-3000Rancher’s Payoff (IF…)

2000Gains From Cooperation

0-200Farmer’s Threat Point

-4000Rancher’s Threat Point

Farmer’s Rights Rancher’s Rights

=



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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

Relating Coase to general equilibrium/first welfare theorem



30

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

Relating Coase to general equilibrium/first welfare theorem



31

Getting backto foxes…



32

Coase seems to say: for efficiency, it doesn’t matter whostarts 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 weall 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 ofquarrels and litigation” – the ensuing lawsuits would be costly

Dissent: killing foxes is a good thing (externality), so lots of peoplebenefit – so hard to get efficient amount of fox hunting throughbargaining

Doesn’t Coase make Pierson v Postirrelevant?



33

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

Transaction costs



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“If market transactions were costless, all that matters (questionsof equity apart) is that the rights of the various parties should bewell-defined and the results of legal actions easy to forecast.

But… the situation is quite different when markettransactions are so costly as to make it difficult to changethe 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 ofrights through market transactions, it is obviously desirable toreduce the need for such transactions and thus reduce theemployment of resources in carrying them out.

Quoting Coase…



35

“In the absence of transaction costs, if property rights arewell-defined and tradable, voluntary negotiations will leadto 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 notransaction costs”

Coase also gives two examples of institutions that mayemerge in response to high transaction costs: Firms

Government regulation

We can see the Coase Theorem as either apositive or negative result



36

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!

Many externalities can be thought of asmissing property rights



37

Demsetz



3838

We motivated property law by looking at agame between two neighboring farmers

10 – c, 10 – c -5 – c, 12 – P

12 – P, -5 – c -P, -P

Farm Steal

Farm

Steal

Player 2

P l a y e r 1

10, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

P l a y e r 1

MODIFIED GAMEORIGINAL GAME

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



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“A primary function of property rights is that of guidingincentives to achieve a greater internalization ofexternalities”

“[ In order for an externality to persist, ] The cost of atransaction in the rights between the parties… must exceedthe gains from internalization.”

“Property rights develop to internalize externalities whenthe gains from internalization become larger than thecost of internalization.”

Harold Demsetz (1967), “Toward a Theoryof Property Rights”



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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




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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




42

The date is 10,000 or 11,000 B.C. You are a member of aprimitive tribe that farms its land in common. Farming land incommon is a pain; you spend almost as much time watching

each other and arguing about who is or is not doing his share asyou do scratching the ground with pointed sticks and pullingweeds.

…It has occurred to several of you that the problem woulddisappear if you converted the common land to private property.Each person would farm his own land; if your neighbor chose notto work very hard, it would be he and his children, not you andyours, that would go hungry.

Friedman tells a similar story: “we owecivilization to the dogs”



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There is a problem with this solution… Private property doesnot 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.




44

Agricultural land continues to be treated as a commons foranother thousand years, until somebody makes a radicaltechnological innovation: the domestication of the dog.

Dogs, being territorial animals, can be taught to identify theirowner’s property as their territory and respond appropriately totrespassers. Now you can convert to private property inagricultural land and sleep soundly. Think of it as the bionicburglar alarm.

-Friedman, Law’s Order, p. 118




Coase: if property rights are complete and tradeable, we’llalways get efficiency

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 completely ignoring costs… Next week: what are transaction costs, how do we deal with them?

So…

Documents

coase THEOREMA