Econ 522 Economics of Law Dan Quint Spring 2013 Lecture 4 Reminder HW1 due midnight Thursday via Learn@UW Aside: what’s going on in my life this week So seriously, don’t try to ask me questions after lecture Wednesday 1 Discussion question Last week, we defined efficiency, and gave a couple arguments why efficiency might be a good normative goal for a legal system Posner: ex-ante consent Cooter and Ulen: better to achieve redistribution through taxes Open discussion question: Aside from efficiency, what are other plausible goals for a legal system? When would you expect them to be in conflict with efficiency? 2 Property Law 3 Why do we need property law? We already saw one reason Tragedy of Commons – overuse of land is held in common For another example, imagine two neighboring farmers Each has two choices: farm his own land, or steal crops from his neighbor Stealing is less efficient than planting my own crops Have to carry the crops from your land to mine Might drop some along the way Have to steal at night move slower If I steal your crops, I avoid the effort of planting and watering 4 Why do we need property law? Suppose that planting and watering costs 5, the crops either farmer could grow are worth 15, and stealing costs 3 With no legal system, the game has the following payoffs: We look for equilibrium Player 1 Player 2 Farm Steal Farm 10, 10 -5, 12 Steal 12, -5 0, 0 Like Prisoner’s Dilemma both farmers stealing is the only equilibrium but that outcome is Pareto-dominated by both farmers farming 5 So how do we fix the problem? Suppose there were lots of farmers facing this same problem They come up with an idea: Institute some property rights And some type of government that would punish people who steal Setting up the system would cost something Suppose it imposes a cost c on everyone who plays by the rules 6 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 So how do we fix the problem? Steal Farm 10 – c, 10 – c -5 – c, 12 – P Steal 12 – P, -5 – c -P, -P If P is big, and c is not too big, then 12 – P < 10 – c In that case, (Farm, Farm) is an equilibrium Payoffs are (10 – c, 10 – c), instead of (0, 0) from before 7 So the idea here… Anarchy is inefficient I spend time and effort stealing from you You spend time and effort defending your property from thieves Instead of doing productive work Establishing property rights, and a legal process for when they’re violated, is one way around the problem This is one way to “internalize externalities” – if I impose a cost on someone else, I’m forced to bear part of that cost 8 Overview of Property Law Cooter and Ulen: property is “A bundle of legal rights over resources that the owner is free to exercise and whose exercise is protected from interference by others” Property rights are not absolute Appendix to ch. 4 discusses different conceptions of property rights Any system has to answer four fundamental questions: What things can be privately owned? What can (and can’t) an owner do with his property? How are property rights established? What remedies are given when property rights are violated? 9 But once we have property rights, we’ll have conflicts between my rights and yours 10 Another story source: http://www.msnbc.msn.com/id/21088150/ 11 How do we design property law to achieve efficient outcomes? 12 Foxes 13 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? 14 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 15 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 16 Coase 17 How should property rights be allocated? Coase’s surprising answer: it doesn’t matter More specifically, under certain conditions, it doesn’t matter for efficiency (Although it does matter for distribution) Coase Theorem: in the absence of transaction costs, if property rights are well-defined and tradable, then voluntary negotiations will lead to efficiency It doesn’t matter how rights are allocated initially… …because if they’re allocated inefficiently, they can be sold/traded until they’re allocated efficiently 18 Example of Coase: you have a car worth $3,000 to you, $4,000 to me Obviously, efficient for me to own it… …but we don’t need the law to give me the car If I start out owning the car: no reason for you to buy it, I end up with it efficient If you start out owning the car: clear incentive for me to buy it, I end up with it efficient Regardless of who owns the car at first, we get to the efficient outcome I’d rather start out with the car – so I don’t have to pay you for it You’d rather start out with it – so you end up with more money Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. And that doesn’t depend on who starts with it. The key: lack of transaction costs 19 Another example: you want to have a party in the house next door to mine If it’s efficient for you to have the party… Your benefit from having the party is greater than my benefit from a good night’s sleep If you start out with the right to have the party, no problem If I start out with the right to quiet, you can pay me for the right to have the party If it’s efficient for you not to have the party… Good night sleep is worth more to me If I have right to silence, no problem If you have right to party, I can pay you not to have it The point: either way, we achieve efficiency If it’s efficient to have the party, you have the party If it’s efficient not to, you don’t Regardless of who started off with the right 20 The conditions for this to hold Property rights have to be well-defined… We need to be clear on who has what rights, so we know the starting point for negotiations …and tradable… We need to be allowed to sell/transfer/reallocate rights if we want …and there can’t be transaction costs It can’t be difficult or costly for us to buy/sell the right 21 The Coase Theorem Ronald Coase (1960), “The Problem of Social Cost” In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency. So the initial allocation of rights doesn’t matter for efficiency However, it does matter for distribution And if there are transaction costs, it may matter for efficiency too 22 Coase’s example: a rancher and a farmer 23 Rancher’s versus farmer’s rights English common law: “closed range” or “fencing-in” (or “farmer’s rights”) Ranchers have responsibility to control their cattle Rancher must pay for any damage done by his herd Much of the U.S. at various times: “open range” or “fencing-out” (or “rancher’s rights”) Rancher can let his cattle roam free Not liable for damage they do to farmer’s crops (unless farmer had a good fence and they broke through anyway) Which rule is more efficient? 24 Open range versus closed range 25 Coase: either law will lead to efficiency If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd… Under open range law, that’s what he’ll do Under closed range law, rancher can pay farmer to build fence If smaller herd is more efficient, farmer can pay rancher to keep fewer cattle Coase: Whatever is the efficient combination of cattle, crops, fences, etc.… …the rancher and farmer will negotiate to that efficient outcome, regardless of which law is in place… …as long as the rights are well-defined and tradable and there are no transaction costs 26 Rancher and farmer: numerical example Three possibilities: Rancher builds fence around herd… costs $400 Farmer builds fence around crops… costs $200 Do nothing, live with damage… costs nothing If expected crop damage = $100 Open range: farmer lives with damage rather than building fence Closed range: rancher pays for damage rather than fence If expected crop damage = $500 Open range: farmer builds fence – efficient Coase: closed range: rancher pays farmer to build fence So efficient outcome under either rule 27 Other examples from Coase Lots of examples from case law a building that blocked air currents from turning a windmill a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door a doctor next door to a confectioner a chemical manufacturer a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation 28 Quoting from Coase (p. 13): Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved. In the case of the cattle and the crops, it is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops. The doctor’s work would not have been disturbed if the confectioner had not worked his machinery; but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place… 29 Quoting from Coase (p. 13): If we are to discuss the problem in terms of causation, both parties cause the damage. If we are to attain an optimum allocation of resources, it is therefore desirable that both parties should take the harmful effects into account when deciding on their course of action. It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties. 30 What does Coase mean by “a cost for both parties”? If the cheapest alternative is for the farmer to build a fence for $200… The cost to build a fence is $200 But the cost to not build a fence is more than $200 – since under a closed-range law, the farmer could ask the rancher for more than $200 to build the fence “Opportunity cost” 31 So, summing up… 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 (But if there are transaction costs, then the initial allocation can matter for efficiency… …and it will always matter for distribution) 32 Bargaining 33 Some vocabulary about bargaining Example from before: Your car is worth $3,000 to you, and $4,000 to me Suppose I have $10,000 $10,000 is my threat point the payoff I can get on my own, by refusing to cooperate with you also called reservation utility, or outside option $3,000 is your threat point Any outcome we both agree to must make us both at least as well-off as our threat point 34 Some vocabulary about bargaining If I don’t buy the car from you… my payoff is 10,000 (my threat point) your payoff is 3,000 combined payoffs are 13,000 If I buy the car for some price P my payoff is 4,000 + 10,000 – P = 14,000 – P your payoff is P combined payoffs are 14,000 – P + P = 14,000 $1,000 are the gains from trade (or gains from cooperation) no trade combined payoffs of $13,000 I buy car combined payoffs of $14,000 if we cooperate, our combined payoffs increase by $1,000 35 Some vocabulary about bargaining Threat points: 10,000 and 3,000 Gains from cooperation: 1,000 Suppose the gains from cooperation were split equally we’d each get 500 more than threat point my payoff would be 10,500, yours 3,500 which means P = $3,500 (Coase doesn’t specify gains will be divided equally, just that they’ll be divided in some way) 36 Let’s go back to the rancher and farmer Cows do $500 damage; fence around herd costs $400; fence around crops costs $200 Rancher’s Rights Rancher’s Threat Point Farmer’s Rights 0 -400 -200 0 Gains From Cooperation 0 200 Rancher’s Payoff (IF…) 0 -300 Farmer’s Threat Point Farmer’s Payoff -200 Combined Payoffs -200 100 = -200 37 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 38 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 39 Getting back to foxes… 40 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 41 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 42 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. 43 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 44 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! 45 That’s it for today HW1 due (online submission) midnight Thursday For Wednesday Demsetz, “Toward a Theory of Property Rights” Calabresi and Melamed, “Property Rules, Liability Rules, and Inalienability: One View of the Cathedral” 46 Demsetz (won’t get to) 47 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 48 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.” 49 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 50 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 51 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. 52 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. 53 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 54 So… Coase: if property rights are complete and tradable, we’ll always get efficiency 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 Of course, Coase wasn’t completely ignoring costs… Next week: what are transaction costs, how do we deal with them? 55