Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 4
Outline
 Last lecture, we…
introduced static games, the matrix representation of payoffs, and
how to find equilibria
 motivated the need for property law (“anarchy is inefficient”)


introduced the Coase Theorem
 Today…

more on Coase
 what are transaction costs, and what happens when they are
present?
 Demsetz on when (and why) property rights develop
1
Coase
2
From last week: 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…

…although it does matter for distribution…

…and it may matter for efficiency if there are transaction costs
3
Example: rancher and farmer
 Three possibilities:



Rancher builds fence around herd… $400
Farmer builds fence around crops… $200
Do nothing, live with damage
 If expected damage = $100…
 If expected damage = $500…
 Coase: “One of the beauties of a smoothly operating
pricing system… the fall in the value of production due
to the harmful effect would be a cost for both parties.”
4
Some vocabulary about bargaining
 Example from before:

Your car is worth $3,000 to you, and $4,000 to me; 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
5
Some vocabulary about bargaining
 Suppose 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



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
 If gains from trade were divided equally…



we’d each get 500 more than threat point
my payoff is 10,500, yours is 3,500, which means P = $3,500
(Coase doesn’t say gains will be divided equally)
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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 Trade
0
200
Rancher’s Payoff (IF…)
0
-300
Farmer’s Payoff
-200
100
Combined Payoffs
-200
-200
Farmer’s Threat Point
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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
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9
Demsetz
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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
 Introduced a cost c of administering a property rights system
11
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.”
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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
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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
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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…
15
Transaction Costs
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So…
 Coase: “in the absence of transaction costs,
if property rights are well-defined and tradeable,
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
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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 as we have seen, 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.
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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 tradeable, 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
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What Are Transaction
Costs?
20
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
21
Bargaining costs come in many forms
 Asymmetric information

Akerloff (1970), “The Market for Lemons” – adverse selection
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
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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
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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
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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
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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
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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
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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
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Coming up…
 Tuesday: how should property rights be enforced?

Calabresi and Melamed, Property Rights, Liability Rules, and
Inalienability: One View of the Cathedral
 No lecture on Thursday October 1
 First HW will be posted soon, due Tuesday October 6
 First midterm Tuesday October 13, on property law
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