Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 5
Monday…
 Coase Theorem: in the absence of transaction costs,
if property rights are well-defined and tradeable, we’ll
always get efficiency

Or: if property rights are complete enough, we can overcome
externalities
 Demsetz: but more complete property rights are more
costly to implement



property rights will expand when the benefits outweigh the costs
either because the benefits rise (Demsetz)…
…or because the costs fall (Friedman)
 Next: what are transaction costs?
1
Transaction
Costs
2
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
3
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
4
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
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
 Uncertainty

If property rights are ambiguous, threat points are uncertain, and
bargaining is difficult
6
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
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
Holdout, freeriding
 Hostility
8
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
9
So, what
do we do?
10
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
11
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
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
 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
13
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
14
Designing an efficient
property law system
15
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?
16
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?
17
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
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
 Liability rule / damages


Damages are a payment to a victim to compensate for actual
damage done
Better when prior negotiation is impossible
 Inalienability
19
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
20
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
21
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
22
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)
23
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
24
How do we choose between the rules?
 In this case…


Polluter’s rights > damages > injunction when there is no
bargaining
All three equally efficient when there is bargaining
 Normative Hobbes: allocate rights efficiently to begin with

Polluter’s rights in this case, no reason to believe this more
generally
 Normative Coase: just work to lower transaction costs, let
people negotiate when they need to
 So what do we do?
25
How do we choose between the rules?
 Injunctions are cheaper for court to implement

No need to calculate exact amount of damage done
 Damages are more efficient when private bargaining fails
 Leads Calabresi and Melamed to the following conclusion:
When transaction costs are high,
a liability rule (damages) is more efficient
When transaction costs are low,
a property rule (injunctive relief) is more efficient
26
So that’s our answer:
 Calabresi and Melamed
When transaction costs are high,
a liability rule (damages) is more efficient
When transaction costs are low,
a property rule (injunctive relief) is more efficient
 Why are damages more efficient when bargaining fails?




Under damages rule, injurer has two choices: prevent the damage,
or pay cost afterwards
Under injunction, injurer has only one choice: prevent the damage
Injuree is compensated, so doesn’t matter to him
So whichever is cheaper for injurer, is more efficient
27
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) 28
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)
29
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.”
30
Third remedy: inalienability
 Inalienability: when an entitlement is not transferable or
saleable
31
what can be privately owned?
what can an owner do?
how are property rights established?
what remedies are given?
32