Econ 522
Economics of Law
Dan Quint
Spring 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
At the end, we related this to General
Equilibrium and the First Welfare Theorem
 GE: consumers and firms take prices as given, optimize
consumption/production; prices are such that markets clear
 First Welfare Theorem: general equilibrium is efficient
 Breaks down when there are externalities, or “missing
markets”

Something in peoples’ utility functions that they can’t demand
 So one way to fix externalities is to “make markets more
complete”

Same as Coase – once we allow trade in something, it should get
allocated efficiently
3
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!
4
Today
 When will it be worth it to expand property rights to correct
an externality problem?
 What do we do when there are transaction costs, so
efficiency is not guaranteed?
5
When are stronger property rights
“worth it”?
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
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
7
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…””
8
- 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.”
9
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.”
10
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
11
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
12
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.
13
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.
14
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
15
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
16
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.”
17
So…
 What are transaction costs, and how do we deal with them?
18
Transaction
Costs
19
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
20
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
21
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
22
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
23
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
24
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
25
Example of high transaction costs when
there are many sellers
26
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
27
So, what
do we do?
28
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
29
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
30
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
31
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
32
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
33
Designing an efficient
property law system
34
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?
35
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
36
Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
37
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
38
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
39
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
40
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
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?
42
we’ll probably end here –
for Monday, read
Calabresi and Melamed
43
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?
44
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)
45
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
46
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
47
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
48
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
49
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)
50
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
51
Comparing injunctions to damages…
 Injunctions are generally cheaper to administer

No need for court to calculate amount of harm done
52
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
53
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
54
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) 55
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)
56
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)
57
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/
58
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
59
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)
60
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.”
61
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
62
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
63
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?

(Examples to come)
 What remedies are given?

Injunctions when transaction costs are low; damages when
transaction costs are high
64