Econ 522
Economics of Law
Dan Quint
Fall 2013
Lecture 5
Reminder
 HW1 due online at 11:59 p.m. Thursday
1
Monday, 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

On the other hand, the initial allocation does affect distribution…

And if there are transaction costs, it can also affect efficiency
2
Foxes
3
One early, “classic” property law case
 Pierson v. Post (NY Supreme Court, 1805)




Lodowick Post organized a fox hunt, was chasing
a fox
Jesse Pierson appeared “out of nowhere,” killed
the fox and took it
Post sued to get the fox back
Lower court sided with Post; Pierson appealed
to NY Supreme Court
 Question: when do you own an animal?
4
One early, “classic” property law case
 Court ruled for Pierson (the one who killed the fox)


“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”
(Also: just because an action is “uncourteous or unkind” does not
make it illegal)
 Dissenting opinion: a fox is a “wild and noxious beast,” and
killing foxes is “meritorious and of public benefit”

Post should own the fox, in order to encourage fox hunting
5
Same tradeoff we saw earlier:
Pierson gets the fox

simpler rule (finders
keepers)

easier to implement

fewer disputes
Post gets the fox

more efficient incentives

(stronger incentive to pursue
animals that may be hard to
catch)
 Just like Fast Fish/Loose Fish vs Iron Holds The Whale


Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes
Iron Holds the Whale is more complicated, but is necessary with
whales where hunting them the old-fashioned way is too dangerous
6
Doesn’t Coase make Pierson v Post
irrelevant?
 Coase seems to say: for efficiency, it doesn’t matter who
starts off with the right to the fox


If Post values it more, he can buy it from Pierson, or vice versa
Seems to imply: one rule is just as good as the other, as long as we
all know what the rule is
 So why does Pierson v Post matter?



Transaction costs!
Majority: if Post gets the fox back, “it would prove a fertile course of
quarrels and litigation” – the ensuing lawsuits would be costly
Dissent: killing foxes is a good thing (externality), so lots of people
benefit – so hard to get efficient amount of fox hunting through
bargaining
7
Transaction costs
 Coase: “in the absence of transaction costs,
if property rights are well-defined and tradable,
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
8
Quoting Coase…
“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.
9
We can see the Coase Theorem as either a
positive or negative result
 “In the absence of transaction costs, if property rights are
well-defined and tradable, 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
10
Many externalities can be thought of as
missing property rights
 Overfishing in communal lake?

It’s because property rights over those fish aren’t well-defined
 Firm polluting too much?

It’s because property rights over clean air aren’t well-defined
 So one solution…



Make property rights complete enough to cover “everything,” and
tradable, and use the law to minimize transaction costs…
…Then Coase kicks in and we get efficiency! (Booya!)
So why not do this? COSTS!
11
Relating Coase to general equilibrium/
first welfare theorem
 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
12
Relating Coase to general equilibrium/
first welfare theorem
 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
13
Bargaining
14
Let’s go back to our
rancher and farmer
Do nothing:
$500 in crop
damage
15
Let’s go back to our
rancher and farmer
Farmer builds
fence: $300
Rancher builds
fence: $400
16
Let’s go back to our
rancher and farmer
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
 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?
17
Before bargaining:
threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
 Threat point – each party’s expected outcome if bargaining
fails
 “If we can’t agree to a deal and we go our separate ways,
how well off am I?”
 Also called outside option, or reservation utility
 Deal has to make everyone better off than that!
18
Threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
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.
19
Threat points
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
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
20
Gains from cooperation
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
 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)
21
So what will happen?
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
 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?
22
So what will happen?
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
 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
23
If gains are split evenly…
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
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
24
If gains are split evenly…
No fence: $500 in harm
Rancher builds fence: $400
Farmer builds fence: $300
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
25
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
26
When are stronger property rights
“worth it”?
27
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
28
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…””
29
- Marginal Revolution (blog post), “Thanksgiving Lessons”
Harold Demsetz (1967), “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.”
30
Harold Demsetz (1967), “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
31
Harold Demsetz (1967), “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
32
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.
33
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.
34
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
35
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
36
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.”
37
So…
 What are transaction costs, and how do we deal with them?
38
Transaction
Costs
39
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
40
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
41
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
42
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
43
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
44
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
45
Example of high transaction costs when
there are many sellers
46
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
47
So, what
do we do?
(won’t get to this)
48
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
49
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
50
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
51
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
52
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
53
That’s it for today
 HW due tomorrow night at midnight
 For next Monday: read Calabresi and Melamed
54