Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 5
Homework
 First homework (efficiency) due midnight Thursday night


Dropbox folder on Learn@UW – upload any electronic file
Email me or Fran if you’re having problems
 Second homework (property law) due two weeks later –
midnight Thursday February 23
1
Last week…
 Coase Theorem: in the absence of transaction costs,
if property rights are well-defined and tradable, we’ll
always get efficiency


Or: if conditions are perfect, initial allocation of rights doesn’t matter
for efficiency
Or, if property rights are complete enough, we can overcome
externalities
 Demsetz: yes, but this comes at a cost

property rights will expand to cover more when gains from fixing
externality exceed costs of administering more complex system
 The Coase result only applies when there are no
transaction costs

Today: transaction costs
2
Transaction
Costs
3
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
4
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
5
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
6
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
7
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
8
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
9
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
10
So, what
do we do?
11
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
12
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
13
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
14
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
15
Designing an efficient
property law system
16
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?
17
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?
18
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)
19
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
20
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
21
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
22
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
23
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)
24
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
25
Comparing injunctions to damages…
 Injunctions are generally cheaper to administer

No need for court to calculate amount of harm done
26
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
27
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
28
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) 29
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)
30
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.”
31
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)
32
Third way to protect an entitlement:
inalienability
 Inalienability: when an
entitlement is not
transferable or saleable

Allocative externalities
(enriched uranium)

“Indirect” externalities
(human organs)
33
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/
34
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
35
(we’ll probably
end here)
36
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?
37
Public versus Private Goods
Private Goods



rivalrous – one’s consumption
precludes another
Public Goods

non-rivalrous

non-excludable
excludable – technologically
possible to prevent
consumption

examples: defense against
nuclear attack
example: apple

infrastructure (roads, bridges)

parks, clean air, large
fireworks displays
38
Public versus Private Goods
 When private goods are owned publicly, they tend to be
overutilized/overexploited
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
40
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
41
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
42
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
43
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
44
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
45
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
46
Up next: applications
47