Econ 522
Economics of Law
Dan Quint
Fall 2013
Lecture 7
Logistics
 HW2 online, due in two weeks (Thurs Oct 10, 11:59 p.m.)
 First midterm is Wednesday October 23

Midterms will be in different room – Education L196
 Starting next week, Nathan’s office hours are switched

Mondays 4-5 and Wednesdays 1-2
1
Example of Coasian bargaining I found
yesterday
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
2
Monday, we “tested the Coase Theorem”
 Can UW undergrads reallocate poker chips efficiently?
 (Cost me $172 to find out)
 What happened?
3
Our experiment…
 Take 1: Full Information (values on nametags)
starting
allocation
efficient
allocation
actual final
allocation
12
red chip
red chip
10
purple chip
purple chip
10
purple chip
purple chip
purple chip
purple chip
purple chip
purple chip
60
60
8
red chip
8
6
fraction of potential
gains realized
purple chip
6
4
purple chip
4
purple chip
2
purple chip
32
100%
4
Our experiment…
 Take 2: Private Information (values hidden)
starting
allocation
efficient
allocation
actual final
allocation
10
red chip
red chip
8
purple chip
purple chip
8
purple chip
purple chip
6
red chip
6
4
fraction of potential
gains realized
purple chip
purple chip
purple chip
purple chip
purple chip
4
3
purple chip
3
purple chip
2
purple chip
24
48
46
22/24 = 92%
5
Our experiment…
 Take 3: Uncertainty




All three chips got sold, at prices around $8
Rolls were 3, 5, and 6, so buyers all made money…
…but trade would still have been efficient if they hadn’t
And we achieved 100% of gains from trade
 Take 4: Asymmetric Information



Rolled 6 and 6
Nobody traded
So we achieved 0% of gains from trade
6
Conclusion
 Coase seems to work pretty well, except when there’s
asymmetric information

Full info: 100% of gains achieved

Private info: 92% of gains

Uncertainty: 100%

Asymmetric info: 0%
7
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 sell
If so, expected payoff is $7
 So information can have negative value!
8
Back to
property law…
9
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?
10
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)
11
So, do we buy it?
 Coase Theorem depends on parties being able to
negotiate privately

Low-TC case: injunctions more efficient, assuming bargaining will
work if “wrong” party is awarded the right
 Does it really work?


Our experiment showed asymmetric information can prevent trade
For more evidence…
12
So, do we buy it?

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.”

So “no TC” case may be rare in real life…
13
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)
14
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)
15
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/
16
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
17
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?
18
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
19
Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
20
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
21
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
22
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
23
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
24
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
25
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?
26
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…
27
“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”
28
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?
29
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
30
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
31
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
32
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
33
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.
34
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
35
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
36
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.
37
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.”
38
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
39
Sequential
Rationality
40
Dynamic games and sequential rationality
 Game theory we’ve seen so far: static games


“everything happens at once”
(nobody observes another player’s move before deciding how to act)
 Dynamic games


one player moves first
second player learns what first player did, and then moves
41
Let’s go back to a game we’ve seen – the
Battle of the Sexes
Player 1
Player 2
Ballgame
Opera
Ballgame
6, 3
0, 0
Opera
0, 0
3, 6
 Now change the game so that player 1 moves first
 Player 1 goes somewhere
 Player 2 learns what 1 did, then decides where to go
42
Dynamic games are typically shown as
“game trees”
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 A strategy is one player’s plan for what to do at each decision
point he/she acts at


Player 1: “Ballgame” or “Opera”
Player 2’s strategy is more complicated – can depend on P1’s choice
43
We can expand the matrix to accommodate
Player 2’s additional options
Player 1
Player 2
Ballgame,
Ballgame
Ballgame,
Opera
Opera,
Ballgame
Opera,
Opera
Ballgame
6, 3
6, 3
0, 0
0, 0
Opera
0, 0
3, 6
0, 0
3, 6
 Player 2 has four options




“Go to the ballgame no matter what”
“Go to the ballgame if P1 went to the ballgame, otherwise opera”
“Opera if P1 went to the ballgame, otherwise ballgame”
“Opera no matter what”
44
We can solve this game for equilibrium in
the “usual” way
Player 1
Player 2
Ballgame,
Ballgame
Ballgame,
Opera
Opera,
Ballgame
Opera,
Opera
Ballgame
6, 3
6, 3
0, 0
0, 0
Opera
0, 0
3, 6
0, 0
3, 6
 Three equilibria:
 1 goes to ballgame, 2 plays “ballgame no matter what”
 1 goes to ballgame, 2 plays “do what 1 did”
 1 goes to opera, 2 plays “opera no matter what”
 Are all of these “reasonable”?
45
Are all these equilibria “reasonable”?
 Consider the equilibrium where


player 2 plans to go to the opera no matter what
player 1 therefore goes to the opera
 Player 1 might wonder…




“Suppose I changed my mind and went to the ballgame.
Once I’m there, player 2 has to choose between sticking to the plan,
going to the opera, and getting 0…
…versus following me to the ballgame and getting 3.
If player 2 is rational and I go to the ballgame, she should follow me
there, and I’ll end up with a payoff of 6!”
46
Sequential rationality
 Sequential rationality is when a player can count on the
other players to behave rationally from that point forward

Similar to “dynamic consistency” (macro)
 When an equilibrium satisfies sequential rationality, we call
it a Subgame-Perfect Equilibrium



Players play best-responses both in the game as a whole, and in
each “subgame,” or part of the game
Rules out the opera-opera equilibrium: in the subgame where P1 had
already gone to the ballgame, P2 wasn’t playing a best-response
In fact, P2 only has one strategy that is sequentially rational: do
whatever player 1 did!
47
Subgame Perfect Equilibria are found by
Backward Induction
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 Start at the “bottom,” solve for what P2 would do at each point
 If P2 is rational and P1 knows it, P1 can infer what payoff he
would get from each move
 Now figure out what P1 would do, given those payoffs
48
Subgame Perfect Equilibria are found by
Backward Induction
PLAYER 1
Ballgame
Opera
PLAYER 2
Ballgame
(6, 3)
PLAYER 2
Opera
(0, 0)
Ballgame
(0, 0)
Opera
(3, 6)
 This game has a unique subgame-perfect equilibrium


Player 1 plays Ballgame
Player 2 plays Ballgame if 1 plays Ballgame, Opera if 1 plays Opera
 “Most” dynamic games have just one SPE
49
Moving first can be good or bad, depending
on the game
 Battle of the sexes: moving first is good




You know your partner will accommodate whatever you do…
…so you get your first choice
Some games: being able to “commit” to a decision, while your
opponent still has to decide, can be good!
(Another example: entry game)
 Scissors-paper-rock: moving first is terrible


You always lose
Some games: reacting to your opponent’s move is good!
50
When we look at dynamic games, we’ll always
look only at subgame-perfect equilibrium
 Key assumption: common knowledge of rationality



Player 1 knows player 2 is rational…
…so whatever he does, she’ll do what’s best for her…
…so player 1 can confidently go to the ballgame
 This is the key to sequential rationality



The assumption that, whatever happens first, players will continue
to act rationally in their own best interest
Which means we can “solve the game” from the end, and figure
out the beginning players’ optimal moves
(Backward induction has been used to solve checkers – it’s a
draw – and will eventually solve chess…)
51