Econ 522
Economics of Law
Dan Quint
Spring 2014
Lecture 7
Monday, we “tested the Coase Theorem”
 Can UW undergrads reallocate poker chips efficiently?
 (Cost me $161 to find out)
 What happened?
1
Our experiment…
 Take 1: Full Information (values on nametags)
starting
allocation
efficient
allocation
actual final
allocation
12
red chip
purple chip
10
purple chip
red chip
10
purple chip
purple chip
purple chip
purple chip
purple chip
purple chip
60
58
8
red chip
8
6
fraction of potential
gains realized
purple chip
6
4
purple chip
4
purple chip
2
purple chip
32
26/28 = 93%
2
Our experiment…
 Take 2: Private Information (values hidden)
starting
allocation
efficient
allocation
actual final
allocation
10
red chip
purple chip
8
purple chip
red chip
8
purple chip
purple chip
purple chip
purple chip
purple chip
purple chip
48
46
6
red chip
6
4
fraction of potential
gains realized
purple chip
4
3
purple chip
3
purple chip
2
purple chip
24
22/24 = 92%
3
Our experiment…
 Take 3: Uncertainty




All three chips got sold, at prices around $8
Rolls were 1, 3, and 6, so one buyer lost money…
…but trade was still efficient
And we achieved 100% of gains from trade
 Take 4: Asymmetric Information



Rolled 3, 3, and 6
One of the 3s got traded, for $6
So we achieved 3/(3+3+6) = 25% of gains from trade
4
Conclusion
 Coase seems to work pretty well, except when there’s
asymmetric information/adverse selection

Full info: 93% of gains achieved

Private info: 92% of gains

Uncertainty: 100%

Asymmetric info: 25%
5
Example of Coasian bargaining I found last
semester
source: http://www.thestar.com/yourtoronto/education/2013/09/19/u_of_t_students_trade_cash_for_seats_in_full_classes.html#sthash.ukMK1JYp.dpuf
6
One other observation: information can be
bad for the person who has it
 Consider a seller in the last two cases

Your value = 2 x die roll, EV = $7.00
 If you know nothing…


Trade at some price between $7 and $10.50
Expected payoff might be $8
 If you know value exactly…


Asymmetric information might mean you can’t trade at all
So expected payoff would be $7
 So expected payoff is higher if you don’t have information,
or the value of the information is negative!
7
Back to
property law…
8
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?
9
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?
10
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)
11
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
12
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
13
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
14
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
15
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)
16
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
17
Comparing injunctions to damages…
 Injunctions are generally cheaper to administer

No need for court to calculate amount of harm done
18
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
19
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
20
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
21
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) 22
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)
23
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.”
24
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 asymmetric
information can be an impediment to trade
25
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)
26
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)
27
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/
28
Another interpretation of inalienability:
bans on “repugnant markets”
 “Repugnant markets”





markets that are illegal because people find
them morally or aesthetically objectionable
CA ban on serving horse and dog meat
Paying birth mother to adopt a child
Bans on dwarf tossing
Ticket scalping, price gouging, gambling,
drugs, prostitution
2012 Nobel Prize winner Al Roth
 Roth: repugnance an important constraint
on markets



What people find repugnant changes over time
Dwarf tossing
Charging interest used to be repugnant!
Repugnance has to be considered in practical market design
29
Our conclusions (from Calabresi/Melamed)
 When transaction costs are low, use injunctive relief
 Either rule will lead to efficient allocation (Coase)…
 …but injunctions are cheaper to implement
(court doesn’t have to assess level of harm)
 When transaction costs are high, use damages
 If bargaining is impossible, damages  more efficient outcomes
 (Example: polluter can choose to pollute and pay when that’s more
efficient than preventing the damage)
 Agrees with principle from textbook
 TC low: design law to facilitate trade (normative Coase)
 TC high: design law to not rely on bargaining (normative Hobbes)
30
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?
31
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
32
Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
33
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
34
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
35
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
36
This accords with the principle from Monday
 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 required to get efficient amount
37
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
38
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?
39
What can an owner do with his property?
 For efficiency: principle of maximum liberty



Owners can do whatever they like with their property…
…provided that doesn’t interfere with others’ property or rights
That is, you can do anything you like so long as it doesn’t impose
an externality (nuisance) on anyone else
 Textbook: common law often approximates rule of
maximum liberty

Does it really? What about bans on repugnant markets? And…
40
“Maximum liberty” vs. government’s right to
regulate
 Ruling two years ago by a Dane County judge
 Plaintiffs argued they had a “fundamental right to own a cow, and to use
their cows in a manner that does not cause harm to a third party”
 Judge responded:
“Plaintiffs do not have a fundamental right to own and use a dairy cow or a dairy herd
Plaintiffs do not have a fundamental right to consume the milk from their own cow
Plaintiffs do not have a fundamental right to board their cow at the farm of a farmer
The private contract does not fall outside the scope of the States’ police power
Plaintiffs do not have a fundamental right to produce and consume the foods of their
choice
DATCP has jurisdiction to regulate the Plaintiffs’ conduct”
41
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?
42
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
43
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
44
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
45
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
46
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.
47
We’ve already seen two examples of this
 “Fast fish/loose fish” and “the guy who kills a fox, owns it”
are examples of a first possession rule

You can’t own a resource until you physically possess it
 “Iron holds the whale” and “the guy chasing a fox owns it”
are examples of a tied ownership rule



You can establish ownership of something before you actually
possess it
(A harpoon, or chasing a fox, gives you a right to it)
More complicated/costly to enforce


“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”
But avoids incentive to poach someone else’s resource
48
Another 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
49
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.
50
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.”
51
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
52