Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 6

Econ 522Economics of Law

Dan Quint

Fall 2013

Lecture 6

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Coase: absent transaction costs, if property rights are complete and tradable, we’ll get efficiency through voluntary negotiation

So we can always get efficient outcomes “automatically”…

…provided there are no transaction costs

But what to do when there are?

Our story so far on property law…

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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

Different types/sources of transaction costs

So if there are transaction costs, what should we do?

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…

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

Two normative approaches to property law

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?

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

So now we have one general principle we can use for designing property law

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The normative Coase approach means relying on bargaining to reallocate rights efficiently

Is it realistic to think this will work in real life?

Is it realistic to think this would work in a room full of undergrad econ majors?

But…

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An experiment on“Coasian bargaining”

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Round 1 (full information) Ten people, five of them have a poker chip to start Each person is given a personal value for a poker chip At the end of the round, that’s how much you can trade in a chip for Purple chip is worth that number, red chip is worth 2 x your number

So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it

Each person can only sell back one chip Your number is on your nametag (common knowledge)

Experiment: Coasian bargaining

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Round 2 (private information) Ten people, five of them have a poker chip to start Each person is given a personal value for a poker chip At the end of the round, that’s how much you can trade in a chip for Purple chip is worth that number, red chip is worth 2 x your number

So if your number is 6 and you end up with a purple chip, I’ll give you $6 for it; if you end up with a red chip, I’ll give you $12 for it

Each person can only sell back one chip Only you know your number


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Round 3 (uncertainty) Six people, three poker chips Value of each chip is determined by a die roll If seller keeps the chip, it’s worth 2 x roll of the die If new buyer buys chip, it’s worth 3 x roll of the die No contingent trades – buyer must pay cash Nobody sees the die roll until the end


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Round 4 (asymmetric information) Six people, three poker chips Value of each chip is determined by a die roll If seller keeps the chip, it’s worth 2 x roll of the die If new buyer buys chip, it’s worth 3 x roll of the die No contingent trades – buyer must pay cash Seller knows the outcome of the die roll, buyer does not


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Back to work

Designing an efficient property law system

what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

Four questions we need to answer

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Injunctive relief: court clarifies right, bars future violation; violations are punished as crimes (but right is tradable)

Damages: court determines how much harm was done by violation, awards payment to injuree

Coase: should be equally efficient if there are no transaction costs

But in “real world”, which is more efficient?

Next question: choosing a remedy for property rights violations

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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 entitled to land free from trespassing animals? Or is the rancher entitled to the natural actions of his cattle?

Calabresi and Melamed treat property and liability under a common framework

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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)

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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

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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

Comparing property/injunctive relief to liability/damages rule

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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

Comparing injunctive relief todamages – example

E profits = 1,000L profits = 300 100E prevention = 500L prevention = 100

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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

First, we consider thenon-cooperative outcomes


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Noncooperative payoffs

8001,1001,200Combined payoff (non-coop)

300300200L payoff(non-coop)

5008001,000E payoff(non-coop)

InjunctionDamagesPolluter’s Rights


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What about with bargaining?

1,2001,2001,200Combined

500350200L payoff (coop)

7008501,000E payoff (coop)

4001000Gains from Coop

8001,1001,200Combined payoff (non-coop)

300300200L payoff(non-coop)

5008001,000E payoff(non-coop)

InjunctionDamagesPolluter’s Rights


800 + ½ (100)

300 + ½ (100)

500 + ½ (400)

300 + ½ (400)

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Injunctions are generally cheaper to administer No need for court to calculate amount of harm done

Comparing injunctions to damages…

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Injunctions are generally cheaper to administer No need for court to calculate amount of harm done

Damages are generally more efficient when private bargaining is impossible Three possibilities: injurer prevents harm, injuree prevents harm,

nobody prevents harm (someone pays for it) Efficiency: cheapest of the three Damages: injurer can prevent harm or pay for it;

injurer chooses whichever is cheapest Injunction: injurer can only prevent harm

Comparing injunctions to damages…

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Any rule leads to efficient outcomes when TC are low

Injunctions are cheaper to implement

Damages lead to more efficient outcomes when TC high

Leads Calabresi and Melamed to the following conclusion:

When transaction costs are low, a property rule (injunctive relief) is more efficient

When transaction costs are high, a liability rule (damages) is more efficient

So now we know…

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Transactions costs low: design law to facilitate trade Property rule does this: clarifies right, allows trade

Transaction costs high: design law to minimize losses due to failures of private bargaining Liability rule does this: gives injurer right to violate entitlement when

efficient, even without prior consent

Exactly agrees with our earlier principle

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“Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy.

On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.”

(Cooter and Ulen)

High transaction costs damagesLow transaction costs injunctive relief

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“When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely.

Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.”

(Cooter and Ulen)

A different view of the high-transaction-costs case…

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Cheaper for the court to administer With low transaction costs, we expect parties to negotiate

privately if the right is not assigned efficiently But… do they really?

Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral

20 nuisance cases: no bargaining after judgment

“In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining…

Frequently the parties were not on speaking terms...

…The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.”

Low transaction costs injunctive relief

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Coase relies on parties being able to negotiate privately if the right is not assigned efficiently Low-TC case: injunctions more efficient, assuming bargaining works

if “wrong” party is awarded the right

But does it work? Paper by Farnsworth shows no bargaining after 20 nuisance cases Our experiment showed various transaction costs that could be a

problem: private information, uncertainty, asymmetric information

So, do we buy it?

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Inalienability: when an entitlement is not transferable or saleable

Allocative externalities(enriched uranium)

Third way to protect an entitlement: inalienability

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“Indirect” externalities(human organs)


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“Indirect” externalities(human organs)

Paternalism


source: http://www.shanghaidaily.com/nsp/National/2011/06/02/Boy%2Bregrets%2Bselling%2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/





Four questions we need to answer

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

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




Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated


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

This accords with a principle we just saw

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Clean air Large number of people affected transaction costs high

injunctive relief unlikely to work well Still two options One: give property owners right to clean air, protected by damages Two: public regulation

Argue for one or the other by comparing costs of each Damages: costs are legal cost of lawsuits or pretrial negotiations Regulation: administrative costs, error costs if level is not chosen

correctly

A different view: transaction costs

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How do we design an efficient property law system?

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Principle of maximum liberty

Owners can do whatever they like with their property, provided it does not interfere with other’ property or rights

That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else

What can an owner do with his property?

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How do we design an efficient property law system?

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Hammonds v. Central Kentucky Natural Gas Co. Central Kentucky leased

land lying above natural gas deposits

Geological dome lay partly under Hammonds’ land

Central Kentucky drilled down and extracted the gas; Hammonds sued, claiming some of the gas was his

(Anybody see “There Will Be Blood”?)

Fugitive property

Hammonds Central KY

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First Possession nobody owns fugitive property until someone possesses it first to “capture” a resource owns it

Central Kentucky would own all the gas

Tied Ownership ownership of fugitive property tied to something else (here,

surface) so ownership already determined before resource is extracted

Hammonds would own some of the gas, since under his land principle of accession – a new thing is owned by the owner of the

proximate or prominent property

Two principles for establishing ownership

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First Possession simpler to apply – easy to determine who possessed property first incentive to invest too much to early in order to establish ownership

example: $100 of gas, two companies drilling fast or slow drilling slowly costs $5, drilling fast costs $25 drill same speed each gets half the gas, one drills fast 75/25

First Possession versus Tied Ownership

45, 45 20, 50

50, 20 25, 25

Slow Fast

Slow

Fast

Firm 2

Firm

1

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First Possession simpler to apply – easy to determine who possessed property first incentive to invest too much to early in order to establish ownership

Tied Ownership encourages efficient use of the resource but, difficulty of establishing and verifying ownership rights

First Possession versus Tied Ownership

45, 45 45, 25

25, 45 25, 25

Slow Fast

Slow

Fast

Firm 2

Firm

1

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Rules that link ownership to possession have the

advantage of being easy to administer,

and the disadvantage of providing incentives for

uneconomic investment in possessory acts.

Rules that allow ownership without possession have

the advantage of avoiding preemptive investment

and the disadvantage of being costly to administer.

This brings us to the following tradeoff:

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Meant to encourage settlement of the Western U.S.

Citizens could acquire 160 acres of land for free, provided head of a family or 21 years old “for the purpose of actual cultivation, and not… for the use or

benefit of someone else” had to live on the claim for 6 months and make “suitable”

improvements

Basically a first possession rule for land – by living on the land, you gained ownership of it

Friedman: caused people to spend inefficiently much to gain ownership of the land

A nice historical example: the Homestead Act of 1862

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“The year is 1862; the piece of land we are considering is… too far from railroads, feed stores, and other people to be cultivated at a profit.

…The efficient rule would be to start farming the land the first year that doing so becomes profitable, say 1890. But if you set out to homestead the land in 1890, you will get an unpleasant surprise: someone else is already there.

…If you want to get the land you will have to come early. By farming it at a loss for a few years you can acquire the right to farm it thereafter at a profit.

Friedman on the Homestead Act of 1862

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How early will you have to come?

Assume the value of the land in 1890 is going to be $20,000, representing the present value of the profit that can be made by farming it from then on. Further assume that the loss from farming it earlier than that is $1,000 a year.

If you try to homestead it in 1880, you again find the land already taken. Someone who homesteads in 1880 pays $10,000 in losses for $20,000 in real estate – not as good as getting it for free, but still an attractive deal.

…The land will be claimed about 1870, just early enough so that the losses in the early years balance the later gains.

It follows that the effect of the Homestead Act was to wipe out, in costs of premature farming, a large part of the land value of the United States.”

Friedman on the Homestead Act of 1862

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What things can be privately owned? Private goods are privately owned, public goods are publicly

provided

What can owners do with their property? Maximum liberty

How are property rights established? (Tradeoff between first possession and tied ownership; more

examples to come)

What remedies are given? Injunctions when transaction costs are low; damages when

transaction costs are high

So, what does an efficient property law system look like?

Documents

Econ 522 Economics of Law Dan Quint Fall 2013 Lecture 6