Econ 522
Economics of Law
Dan Quint
Fall 2015
Lecture 5
Reminders
 No class on Wednesday (Yom Kippur)

G’mar Hatima Tovah
 If you want to read ahead:

Guido Calabresi and Douglas Melamed, “Property Rules, Liability
Rules, and Inalienability: One View of the Cathedral”
1
Last week, 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

Basically, allow people to bargain, and they’ll bargain to efficiency
2
Nice interpretation/example from a paper
we’re talking about today
“There are two striking implications… that are true in a world of zero
transaction costs.
The output mix that results when the exchange of property rights is
allowed is efficient,
and the mix is independent of who is assigned ownership.
For example, the the efficient mix of civilians and military will result
from transferable ownership no matter whether taxpayers must hire
military volunteers or whether draftees must pay taxpayers to be
excused from service.
For taxpayers will hire only those military (under the “buy-him-in”
property right system) who would not pay to be exempted (under the
“let-him-buy-his-way-out” system).”
Harold Demsetz (1967), Toward A Theory of Property Rights
3
Bargaining
4
Let’s go back to our
rancher and farmer
Do nothing:
$500 in crop
damage
5
Let’s go back to our
rancher and farmer
Farmer builds
fence: $300
Rancher builds
fence: $400
6
Let’s go back to our
rancher and farmer
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
 Three possibilities



Nobody builds a fence – $500 in damage
Rancher builds fence – $400 cost
Farmer builds fence – $300 cost
 Suppose we’re in a farmer’s rights world

Rancher is liable for any damage done by his herd
 What does Coase predict will happen?



They’ll bargain to efficient outcome
Meaning, the farmer will build a fence (and the rancher will pay him)
How much will he pay?
7
Before bargaining:
threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
 Threat point – each side’s anticipated outcome if
bargaining fails
 “If we can’t agree to a deal and we go our separate ways,
how well off am I?”
 Negotiation textbooks call this your BATNA –
“Best Alternative To a Negotiated Agreement”

Also called outside option, or reservation utility
 Deal has to make everyone better off than that!
8
Threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
What happens to me if I don’t
reach a deal with the
rancher?
Well, he’s liable for any crop
damage…
…so there’s no reason for me
to build a fence…
…and if there’s any damage,
he’ll have to reimburse me…
…so if bargaining breaks
down and I do nothing,
my payoff is 0.
That’s the best I can do on
my own…
…so that’s my threat point.
9
Threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
What happens if I don’t reach
a deal with the farmer?
He has no reason to build a
fence…
…and I’m liable for crop
damage…
…so my choices are to pay
for $500 in damage…
…or to build a $400 fence
So clearly, I’ll build a fence
So my payoff if we don’t
make a deal is –$400
So that’s my threat point
10
Gains from cooperation
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
 So under a closed-range law…
 The farmer’s threat point is 0, the rancher’s is –$400

Those are the payoffs that will happen if no agreement is reached
 If a deal happens: total payoffs go up from –$400 to –$300

Farmer will build a fence (efficient outcome), rancher will pay him
some money
 Cooperation causes total payoffs to go up by $100
 So $100 is gains from cooperation (or gains from trade)
11
So what will happen?
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
 Coase predicts negotiation will lead to efficiency


So the gains from cooperation will be realized
(The farmer will build a fence)
 Both sides have to do at least as well as their threat point

Otherwise, wouldn’t agree to deal
 So rancher will pay farmer somewhere between $300 and
$400 to build the fence

But what if we want a more precise prediction?
12
So what will happen?
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
 What if gains from cooperation were split evenly?
 Threat points 0 and –400, gains of 100
 Farmer’s payoff: 0 + ½ (100) = 50
 Rancher’s payoff: –400 + ½ (100) = –350
 How is this achieved? Rancher pays farmer $350 to build
fence
13
If gains are split evenly…
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
Farmer’s Rights
Rancher’s Threat Point
-400
Farmer’s Threat Point
0
Gains From Cooperation
100
Rancher’s Payoff (IF…)
–400 + ½ (100) = –350
Farmer’s Payoff
0 + ½ (100)
Combined Payoffs
= 50
-300
14
If gains are split evenly…
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
Law: Farmer’s Rights
Rancher’s Rights
Rancher’s Threat Point
Farmer’s Rights
0
-400
-300
0
Gains From Cooperation
0
100
Rancher’s Payoff (IF…)
0
-350
Farmer’s Threat Point
Farmer’s Payoff
-300
Combined Payoffs
-300

50
=
-300
15
One more example – you having a party
next door to my house
 Let’s suppose…



Having the party is worth $150 to you…
…and a good night’s sleep is worth $100 to me
So it’s efficient to have the party
 If parties are allowed…

No need for negotiation
 If parties are not allowed…





My threat point: 0
Your threat point: 0
Gains from cooperation: $50
If split evenly: payoffs are $25 and $25
Which requires you paying me $125 to have the party
16
When are stronger property rights
“worth it”?
17
ORIGINAL GAME
MODIFIED GAME
Player 2
Player 2
Farm
Steal
Farm
10, 10
-5, 12
Steal
12, -5
0, 0
Farm
Player 1
Player 1
We motivated property law by looking at a
game between two neighboring farmers
Steal
Farm 10 – c, 10 – c -5 – c, 12 – P
Steal 12 – P, -5 – c
-P, -P
 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
18
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…””
19
- Marginal Revolution (blog post), “Thanksgiving Lessons”
Harold Demsetz, “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.”
20
Harold Demsetz, “Toward a Theory of
Property Rights”
 “A close relationship existed, both historically and geographically,
between the development of private rights in land and the development
of the commercial fur trade.
 Because of the lack of control over hunting by others, it is in no
person’s interest to invest in increasing or maintaining the stock of
game. Overly intensive hunting takes place.
 Before the fur trade became established, hunting was carried on
primarily for purposes of food and the relatively few furs that were
required for the hunter’s family. The externality was clearly present…
but these external effects were of such small significance that it did not
pay for anyone to take them into account.”
21
Harold Demsetz, “Toward a Theory of
Property Rights”
 “The advent of the fur trade had two immediate consequences. First,
the value of furs to the Indians was increased considerably. Second,
and as a result, the scale of hunting activity rose sharply. Both
consequences must have increased considerably the importance of the
externalities associated with free hunting. The property right system
began to change…”
 …even though property rights were not developing in the Southwest,
where the commercial fur trade had not developed
22
Harold Demsetz, “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
23
Harold Demsetz, “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
24
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.
25
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.
26
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
27
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
28
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.”
29
So…
 What are transaction costs, and how do we deal with them?
30
Transaction
Costs
31
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
32
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
33
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
Quality
of car
Probability
Value
to Me
Value
to You
Great
1/3
$6,000
$4,000
Decent
1/3
$3,000
$2,000
Terrible
1/3
$0
$0
Average value to me: $3,000
Average value to me: $1,500
34
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
35
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
36
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
37
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
38
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
39
So, what
do we do?
40
What we know so far…
 No transaction costs / bargaining is easy
 initial allocation of rights doesn’t matter for efficiency

wherever they start, people will trade until efficiency is achieved
 Significant transaction costs / bargaining is hard
 initial allocation does matter, since trade may not occur
(and is costly if it does)
 This leads to two normative approaches we could take


Minimize the cost of bargaining
Minimize the need for bargaining
41
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
42
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
43
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
44
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
45
That’s it for today
 For next week: Calabresi and Melamed
46