Econ 522
Economics of Law
Dan Quint
Fall 2011
Lecture 4
Last week, we…
 …defined some important tools



defined efficiency, and gave reasons for why we might want the law
to be designed to be efficient
showed how externalities (among other things) lead to inefficiency
introduced static games, the matrix representation of payoffs, and
how to find equilibria
 …showed two ways in which a lack of clear property rights
can lead to severe inefficiencies


overfishing example
farming/stealing game
1
Once we have private property rights, we’ll
have conflicts between mine and yours
 My neighbor likes tall trees

can he plant a tree on his property if it shades my pool, or blocks
my view?
 You want to have a party


do you have the right to make noise in your house?
or do I have the right to a good night’s sleep in my house?
 I own a small power plant located on a river


do I have a right to use water from the river for cooling?
do I have a right to pollute as much as I want?
2
Up next: how should we design property
rights to achieve efficiency?
 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”
 Doesn’t tell us how property law should be designed
 Need 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?
Today: wild animals and Coase
3
Foxes
4
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?
5
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
6
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
7
Coase
8
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
9
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
10
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
11
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
12
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
13
Coase’s example: a rancher and a farmer
14
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?
15
Open range versus closed range
16
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
17
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
18
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
19
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…
20
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.
21
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”
22
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…

…although it does matter for distribution…

…and it only works if there are no transaction costs

If there are transaction costs, then the initial allocation can matter
for efficiency
23
Bargaining
24
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
25
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
26
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)
27
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
28
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
29
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
30
Getting back
to foxes…
31
Why 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
32
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
33
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.
34
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
35
Wednesday: transaction costs
 What are transaction costs?
 If there are transaction costs…


how we allocate rights does matter for efficiency
so what should we do?
 But we’ll begin with Demsetz, “Toward a Theory of
Property Rights”
36
Demsetz
( probably won’t get to on Monday)
37
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
38
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.”
39
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: medium
Before fur trade…


externality was small, so gains from internalization were small
gains < costs  no private ownership of land
40
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: medium
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
41
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.
42
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.
43
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
44
So…
 Coase: if property rights are complete and tradeable, 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…

Wednesday: what are transaction costs, how do we deal with them?
45