Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 4

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Last lecture, we… introduced static games, the matrix representation of payoffs, and

how to find equilibria motivated the need for property law (“anarchy is inefficient”) introduced the Coase Theorem

Today… more on Coase what are transaction costs, and what happens when they are

present? Demsetz on when (and why) property rights develop

Outline

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Coase

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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…

…although it does matter for distribution…

…and it may matter for efficiency if there are transaction costs

From last week: the Coase Theorem

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Three possibilities: Rancher builds fence around herd… $400 Farmer builds fence around crops… $200 Do nothing, live with damage

If expected damage = $100…

If expected damage = $500…

Coase: “One of the beauties of a smoothly operating pricing system… the fall in the value of production due to the harmful effect would be a cost for both parties.”

Example: rancher and farmer

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Example from before: Your car is worth $3,000 to you, and $4,000 to me; 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 least as well-off as our threat point

Some vocabulary about bargaining

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Suppose 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 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

If gains from trade were divided equally… we’d each get 500 more than threat point my payoff is 10,500, yours is 3,500, which means P = $3,500 (Coase doesn’t say gains will be divided equally)

Some vocabulary about bargaining

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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 Trade

0-200Farmer’s Threat Point

-4000Rancher’s Threat Point

Farmer’s RightsRancher’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

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Demsetz

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We motivated property law by looking at a game between two neighboring farmers

10 – c, 10 – c -5 – c, 12 – P

12 – P, -5 – c -P, -P

Farm Steal

Farm

Steal

Player 2

Pla

yer

110, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

Pla

yer

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MODIFIED GAMEORIGINAL GAME

Changing the game had two effects: Allowed us to “cooperate” by not stealing Introduced a cost c of administering a property rights system

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“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”

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“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: medium 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”

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“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: medium 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

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

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Coase: if property rights are complete and tradeable, we’ll always 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…

So…

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Transaction Costs

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Coase: “in the absence of transaction costs, if property rights are well-defined and tradeable, 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

So…

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“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 as we have seen, 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.

Quoting Coase…

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“In the absence of transaction costs, if property rights are well-defined and tradeable, 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

We can see the Coase Theorem as either a positive or negative result

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What Are Transaction Costs?

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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

What are transaction costs?

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

Bargaining costs come in many forms

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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

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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

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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

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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

Bargaining costs come in many forms

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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

Sources of transaction costs

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So, what do we do?

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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

What we know so far…

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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

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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

Two normative approaches to property law

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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

Which approach should we use?

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Tuesday: how should property rights be enforced? Calabresi and Melamed, Property Rights, Liability Rules, and

Inalienability: One View of the Cathedral

No lecture on Thursday October 1

First HW will be posted soon, due Tuesday October 6

First midterm Tuesday October 13, on property law

Coming up…