Econ 522
Economics of Law
Dan Quint
Spring 2014
Lecture 6
Announcements
 First midterm: Monday March 3
 Second midterm: Wednesday April 16
1
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 fo
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.”
2
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
3
Demsetz also gives a nice interpretation/
example of the Coase Theorem
“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).”
4
Our story so far on property law…
 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?
5
Different types/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
6
So if there are transaction costs,
what should 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
But…
 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?
13
An experiment on
“Coasian bargaining”
14
Experiment: Coasian bargaining
 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)
15
Experiment: Coasian bargaining
 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
16
Experiment: Coasian bargaining
 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
17
Experiment: Coasian bargaining
 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
18
Back to work
19
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?
Next question: choosing a remedy for
property rights violations
 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?
22
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 entitled to land free from trespassing animals?
Or is the rancher entitled to the natural actions of his cattle?
23
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)
24
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
25
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
26
Comparing injunctive relief to
damages – example
E profits = 1,000
L profits = 300  100
E prevention = 500
L prevention = 100
 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
27
First, we consider the
non-cooperative outcomes
E profits = 1,000
L profits = 300  100
E prevention = 500
L prevention = 100
 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
28
E profits = 1,000
L profits = 300  100
E prevention = 500
L prevention = 100
Noncooperative payoffs
Polluter’s Rights
Damages
Injunction
E payoff
(non-coop)
1,000
800
500
L payoff
(non-coop)
200
300
300
1,200
1,100
800
Combined payoff
(non-coop)
29
What about with bargaining?
Polluter’s Rights
Damages
E profits = 1,000
L profits = 300  100
E prevention = 500
L prevention = 100
Injunction
E payoff
(non-coop)
1,000
800
500
L payoff
(non-coop)
200
300
300
Combined payoff
(non-coop)
1,200
1,100
800
Gains from Coop
0
100
400
E payoff (coop)
1,000
800 + ½850
(100)
500 + ½
(400)
700
L payoff (coop)
200
300 + ½350
(100)
300 + ½
(400)
500
Combined
1,200
1,200
1,200
30
Comparing injunctions to damages…
 Injunctions are generally cheaper to administer

No need for court to calculate amount of harm done
31
Comparing injunctions to damages…
 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
32
So now we know…
 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
33
Exactly agrees with our earlier principle
 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
34
High transaction costs  damages
Low transaction costs  injunctive relief
“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) 35
A different view of the high-transaction-costs
case…
“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)
36
Low transaction costs  injunctive relief
 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.”
37
So, do we buy it?
 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
38
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)
39
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)
40
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)

Paternalism
source: http://www.shanghaidaily.com/nsp/
National/2011/06/02/Boy%2Bregrets%2Bselling
%2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/
41
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
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
A different view: transaction costs
 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
49
How do we design an efficient property law
system?
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
50
What can an owner do with his property?
 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
51
How do we design an efficient property law
system?
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
52
Fugitive property
 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”?)
Hammonds
Central KY
53
Two principles for establishing ownership
 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
54
First Possession versus Tied Ownership
 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
Firm 2
Firm 1

Slow
Fast
Slow
45, 45
20, 50
Fast
50, 20
25, 25
55
First Possession versus Tied Ownership
 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
2
but, difficulty of establishing andFirm
verifying
ownership rights
Firm 1

Slow
Fast
Slow
45, 45
45, 25
Fast
25, 45
25, 25
56
This brings us to the following tradeoff:
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.
57
A nice historical example: the Homestead
Act of 1862
 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
58
Friedman on the Homestead Act of 1862
“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.
59
Friedman on the Homestead Act of 1862
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.”
60
So, what does an efficient property law
system look like?
 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
61