Econ 522 – Lecture 5 (Feb 3 2009)
So far in property law…
 we’ve seen Coase, who argued that the initial allocation of property rights
shouldn’t matter for efficiency, as long as they’re tradeable and there are not
transaction costs
 we’ve seen Demsetz, who argued that more complete property rights always come
at a cost, and that property rights will expand as the gain outweighs this cost
o Demsetz gives the example of private hunting rights on family land, which
developed among Native Americans at the time the commercial fur trade
was emerging
 we discussed sources of transaction costs – that is, things that could get in the way
of Coase’s conclusion that private negotiations will always lead to efficiency
o search costs
o enforcement costs
o several sources of bargaining costs
 asymmetric information
 uncertainty over the other party’s threat point
 large numbers of parties to a transaction, which can lead to holdout
by sellers or freeriding by buyers
 hostility
 Coase’s conclusion – that we’ll always bargain our way to efficiency when there
are no transaction costs, but that when there are transaction costs, we might not –
led us to two different normative approaches to the law:
o structure the law to minimize transaction costs (“lubricate” bargaining)
o structure the law to minimize harm caused by failures in private
agreements (or roughly, allocate rights efficiently to begin with)
 and we wrapped up with Cooter and Ulen’s rule for when each approach is
appropriate:
o when transaction costs are low and information costs are high, structure
the law to minimize transaction costs
o 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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while these seem like reasonable principles, it’s not immediately apparent how
you would actually implement them
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which brings us to today’s first topic: an important paper from 1972 by Guido
Calabresi and Douglas Melamed, titled, “Property Rules, Liability Rules, and
Inalienability: One View of the Cathedral”
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the topic of the Calabresi and Melamed paper is how property rights are enforced,
that is, what remedies are used when rights are violated
Calabresi and Melamed state that their goal is to treat both property and liability
law under a common framework, rather than keeping them as distinct topics
we’ve already been doing this
o when we think about the rancher-farmer question, we can pose it in terms
of liability – is the rancher liable for the damage his herd does?
o or we can pose it in terms of property – does the farmer’s right to his
property include the right to be free from trespassing cows? or does the
rancher’s right to his herd include the right to not be punished when they
stray?
Calabresi and Melamed consider both cases to be cases of “entitlements”
o is the farmer entitled to land without trespassing animals, or is the rancher
entitled to be free from herd-damage liability?
o Similarly, are you entitled to have a noisy party, or am I entitled to get a
good night’s sleep?
Calabresi and Melamed discuss three possible enforcement rules for protecting an
entitlement.
1. Property Rules, or Injunctive Relief
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This is when you are legally barred from violating my entitlement without my
prior agreement
This is the usual rule for protecting private property – if it’s mine, you simply
can’t take it unless I give it to you
And if you do choose to take it, you’ve committed a crime – you don’t just owe
me the value of what you took, you may go to jail, you may face other severe
consequences
(the idea of a property rule is that the punishment is so severe, you’ll never choose
to violate my right without my permission)
An injunction is basically a court order clarifying someone’s rights and
specifically barring someone from violating them
For example, if a factory is polluting and the neighbors object and take it to court,
the court might issue an injunction, which would bar the factory from further
pollution
The factory could still negotiate with the neighbors and reach some bargain where
the neighbors agree not to enforce the injunction, but this would be completely at
the discretion of the neighbors
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2. Liability Rules, or Damages
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These is when you can violate my entitlement without my agreement, but must
compensate me afterward for whatever damages I incur
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under a liability or damages rule, the factory could go on polluting, and the
neighbors would sue them for damages
the court would then have to calculate an objective value of the damage done
the neighbors can argue that the damage incurred was high, but they are only
awarded what is considered fair value, not what they argue they would have held
out for in the beginning
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This is the type of rule behind eminent domain, which we’ll talk about in a bit
o if the government wants to build a school, or an army base, or a town
dump, on land that I own, they can force me to sell my land
o and they can force me to sell at what is considered fair market value, not
to hold out for whatever amount I want based on my sentimental
attachment to the house I grew up in or anything else
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Liability rules obviously work better than property rules in settings where prior
negotiation is impossible
o Clearly, I have an entitlement to not be hit by someone’s car when I’m
walking, but it’s hard to imagine them approaching me beforehand and
bargaining for the right to hit me.
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Another difference: damages are backward-looking – they compensate for harm
already done, while injunctions and property rules are forward-looking – they
specifically forbid future harms from occurring.
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A property rule will always be more favorable toward the injuree (the person
whose entitlement is to be violated), and a liability rule will always be more
favorable toward the injurer
This is because the punishment for violating an injunction without the other side’s
permission is much harsher than damages – it may involve criminal trespass or
violating a court order
So when the two sides bargain, the injurer will have a much lower threat point
when facing an injunction, so the injuree will end up with a higher payoff if they
do choose to cooperate
(We’ll see an example.)
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We know from Coase that in a world without transaction costs, either rule should
be sufficient to allow private bargaining to lead to efficiency
However, since the two rules give the two sides different threat points, they
change the payoff achieved by each side during negotiations
In a world with transaction costs, of course, they may lead to different results
Consider the example in Cooter and Ulen
There is an electric company E that emits smoke, which dirties the laundry at a
laundromat L next door
The electric company earns profits of 1000, and could stop emitting smoke by
installing scrubbers in its smokestack, at a cost of 500.
Without smoke, the laundromat earns profits of 300. Smoke does $200 of
damage (reducing profits to 100)
The laundromat could also avoid the damage by installing filters on its ventilation
system, at a cost of 100.
Let’s look at the noncooperative results under different legal rules – that is, the payoffs
each side would achieve under different rules, if they didn’t bargain with each other
Polluter’s Rights:
E earns 1000, L installs filters and earns 200
Pollutee has right to Damages:
E earns 800 after paying damages; L earns 300
Pollutee has an Injunction:
E installs scrubbers, earns 500; L earns 300
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Clearly, the efficient outcome is for L to install filters, leading to combined profits
of 1200
(This avoids $200 in damage at a cost of $100, and is the cheapest way to avoid
the damage.)
This is the outcome that occurs in the Polluter’s Rights case
In the other two cases, the noncooperative outcome is inefficient
But if there are not transaction costs, the two sides could still negotiate an
agreement to achieve efficiency
But in each case, the threat points would be different, so the division of surplus
will be different under the different rules.
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DO THIS SLOWLY
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Under Damages, the threat points are 800 and 300
And there is an additional 100 to be gained by cooperating
o avoiding $200 in damage by installing filters for $100
Suppose these gains from cooperation are split evenly
Then the Damages rule, without transaction costs, leads to profits of 850 and 350
Under an Injunction, the threat points are 500 and 300
And there is an additional 400 to be gained by cooperating
o avoiding the damage using $100 filters instead of $500 scrubbers
If this additional surplus is split evenly, it leads to profits of 700 and 500.
What would our two normative principles say about the different rules?
Under Normative Hobbes, the initial allocation should be chosen to be efficient;
in this case, this is Polluter’s Rights
o (There’s no reason for this to be true more generally, just in this example.)
Under Normative Coase, if transaction costs are lowered sufficiently, efficiency
will be reached under any of the rules; the law should be designed in a way that
makes transaction costs as small as possible
(We’ll come back to this in a bit.)
But which rule is more efficient in general?
An injunction is cheaper for a court to implement
o the court simply clarifies the property right; it does not have to calculate
the exact amount of damage that was done
o damages are more difficult for a court to implement, since they must
assess the monetary value of damage that was done
o (We’ll return to the question of how damages are computed when we get
to tort law; but for now, just realize this requires going to court, expert
testimony, and a judgment.)
However, in this example, if private bargaining fails, damages lead to a more
efficient result than an injunction, and this turns out to be true more generally
This leads Calabresi and Melamed to the following conclusion:
When transaction costs are high (or there are impediments to private negotiations),
a liability rule (damages) is more efficient
When transaction costs are low (or private negotiations can be expected to succeed),
a property rule (or injunctive relief) is more efficient
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Why is liability more efficient when bargaining is likely to fail?
Think of it this way
In the example we just saw, there were three ways to deal with the harm: the
electric company could prevent it, the laundry could prevent it, or they could both
just let it happen and deal with it
When the two parties bargain, they’ll always choose whichever of the three is
cheapest – so they’ll get the efficient outcome
When the two parties don’t bargain, under an injunction, the electric company has
only one choice: prevent the harm itself
Under a damages rule, it has two choices: prevent the harm itself, or allow the
harm to occur and pay damages
Since the electric company faces the full cost in either case, it will choose the
cheaper option, and therefore the more efficient option
When the electric company can prevent the harm at a lower cost than the cost of
the harm itself, injunctions or damages will lead to the same outcome
When it can not, injunctions will be more costly than damages
Cooter and Ulen use this to explain how things are typically done in certain types
of disputes
“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 also point out, though, that in the first case – where transaction
costs are high, so bargaining is likely to fail – a liability rule is only efficient
when the court is able to correctly calculate the amount of damages
On the other hand, injunctive relief is efficient any time the court can determine
who values the right more, regardless of its absolute level
This leads them to a different interpretation of efficient remedies in the hightransaction-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.”
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In the case where transaction costs are low, however, injunctive relief is assumed
to be more efficient
o because it tends to be simpler and clearer and therefore more likely to
encourage negotiations
Calabresi and Melamed defend injunctions as being optimal by assuming that the
parties will privately negotiate after the court rules
Cooter and Ulen (on their website) mention a paper by Ward Farnsworth,
examining whether this occurs.1 Quoting:
Farnsworth "examines twenty nuisance cases and finds no bargaining after judgment
in any of them; nor did the parties’ lawyers believe that bargaining would have
occurred if judgment had been given to the loser. The lawyers said that the
possibility of such bargaining was foreclosed not by the sorts of transaction costs that
usually are the subject of economic models, but by animosity between the parties
and by their distaste for cash bargaining over the rights at issue."
Naturally, Professor Farnsworth asked the lawyers why they though that no
bargaining occurred after judgment. The lawyers cited two impediments to postjudgment bargaining. "First, in almost every case the lawyers said that acrimony
between the parties was an important obstacle to bargaining. The parties in these
cases often thought that their adversaries were behaving in ways that were
unreasonable, discourteous, and unneighborly. Frequently the parties were not on
speaking terms by the time the case was over (sometimes much earlier). ... The
second recurring obstacle involves the parties’ disinclination to think of the rights at
stake in these cases as readily commensurable with cash."
As the title of the paper suggests, Calabresi and Melamed also talk about a third type of
protection for entitlements: inalienability
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This is when an entitlement is not transferable or sellable
For example, I an entitled to not be a slave, and I am not allowed to give away or
sell that right
Similarly, you can’t give away or sell your right to vote
Inalienability is a bit of a funny case
The word might resonate as being a positive one – think of the well-known line
from the Declaration of Independence, that all men are endowed with “certain
unalienable Rights, that among these are Life, Liberty and the pursuit of
Happiness”
But in our context, inalienability seems more negative
Ward Farnsworth, “Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside the
Cathedral,” 66 U. Chi. L. Rev. 373 (1999).
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Everything we’ve done so far – in particular, Coase – has assumed that the way to
get efficient outcomes it to allow people to trade rights with each other, in order to
get them owned by whoever values them the most
I own two kidneys; some kidney patient needs one; if my second kidney is worth
more to him than to me, why shouldn’t I be allowed to sell it to him?
In some cases, we can defend inalienability by talking about externalities
o If giving away a particular right imposed a large externality on others,
maybe it makes sense not to allow it
In other cases, it seems to be more a case of paternalism
o that is, the government thinking it knows what is good for you
(We can think of this as the case of owning a historical landmark: it is your
property, but it may be unalienable, in that you cannot sell it to someone who
would put it to a different use.)
In the laundry example, we considered three possible rules that could apply:
o the electric company is free to pollute unless they reached a bargain with
the laundry not to
o the electric company could pollute and pay damages
o the electric company could only pollute if they negotiated an agreement
with the laundry (injunction)
Calabresi and Melamed point out that there is also a fourth option:
consider a rule where the electric company is allowed to pollute, but the laundry
could stop them, not by bargaining with them, but by paying objective (courtdecided) damages
That is, we would start in a world of polluter rights, but give the pollutee the right
to veto the pollution and pay the electric company for whatever losses this caused
them
(We can think of this as “reverse damages”)
(In the example we did above, this would not be efficient; but Calabresi and
Melamed point out some instances in which it might be.)
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Recall the four key questions we said that any system of property law must address:
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What things can be privately owned?
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What can (and can’t) an owner do with his property?
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How are property rights established?
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What remedies are given when property rights are violated?
Calabresi and Melamed address question 4, remedies. And we’ve talked a bit about
question 2, what an owner can or can’t do with his property, in the context of nuisance
law – we’ll come back to it later (briefly).
Now we turn to the question of what can be privately owned.
You may recall from micro a discussion of Public and Private Goods.
Private Goods tend to be characterized by two properties:
 Rivalrous – one person’s consumption of a private good precludes another
person’s enjoyment of its benefits
 Excludable – it’s technologically possible to prevent others from consuming it
Good example is an apple. If you eat my apple, I can’t eat it; but it shouldn’t be too hard
for me to prevent you from eating it.
Public Goods tend to be characterized by the opposite of these two properties:
 Nonrivalrous – one person’s consumption of a public good does not impact
others’ enjoyment of it
 Nonexcludable – hard to prevent people from taking advantage
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The cleanest example of a public good is defense against a nuclear attack
o It’s very hard for me to defend myself from a nuclear attack in a way that
doesn’t also protect you a bit
o and you being safe from nuclear attack doesn’t impact my enjoyment of
this privilege.
Other public goods are urban infrastructure (bridges and roads) (although roads
may become somewhat rivalrous when there is congestion); parks, clean air, the
ocean, large fireworks displays, and so on.
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A principle you may remember from intermediate micro: When private goods are
owned publicly, they tend to be overutilized, or overexploited.
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This is the point of the classic paper by Hardin on the syllabus, the tragedy of the
commons
His example: a large common area where everyone is permitted to graze their
cattle
Since it’s public, nobody considers the cost their herd imposes on the grass
So the grass on the commons gets wiped out by overgrazing
Another example of this is congestion on busy roads
Most roads are provided publicly (no toll, free to use)
When there’s lots of traffic, roads become rivalrous – the more people on the
road, the less utility I get from driving on them – so they take on one of the
characteristics of a private good
But when people are deciding whether or not to drive, they tend not to consider
the externality that their choice to drive has on other drivers; so the roads get
overused
Some cities are looking at ways to solve this problem with congestion pricing –
charging people to use the roads during peak hours, so that people internalize this
externality.
One the other hand, when public goods are privately owned, they face the opposite
problem: they will be underprovided
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suppose a town wants to build a park, but has to pay for it with voluntary
donations
people weigh their donations only against their private gain from the park,
ignoring the positive effect it has on everyone else
so people will donate very little, and a nice park will not be built in this way
this is exactly the free-rider problem we talked about earlier when we were
considering bargaining
Example: 100 people, each with utility 10 sqrt( Park ) + $, where Park is the sum
of everyones’ contributions.
o When each person decides how much to contribute, he maximizes
10sqrt(X+x) – x, where X is what everyone else contributed
o Solving the problem establishes that when contributions are voluntary,
X+x=25 – total contributions will be 25, giving everyone an average
utility of 10 sqrt (25) – 25/100 = 49.75
o On the other hand, suppose everyone agreed to contribute $1 each; a park
of quality 100 would be built, leading everyone to utility of 10 sqrt( 100 )
– 1 = 99
o So obviously, the bigger park is Pareto-superior, even though only the
small one could be built through voluntary private contributions.)
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Recall our earlier story of a hops farmer and a brewery
When there was a single hops farmer, he could negotiate with the brewery to
reduce pollution and breathe cleaner air
But if the dirty air affects lots of people, it becomes a “public bad” – and if each
person tries to negotiate separately with the brewery to reduce pollution, they will
reduce it less than efficiency would suggest.
Which brings us to the general rule proposed by Cooter and Ulen:
 Efficiency suggests that private goods should be privately owned, and public
goods should be publicly provided or regulated
 Private ownership of private goods avoids overuse, and allows trade, leading to
efficient allocations (Coase)
 Public provision of public goods avoids undersupply
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This also gives us another interpretation of the Demsetz example we did last
week, of the development of property rights to land among Native Americans
What makes the case interesting is that land can be either a public or a private
good, depending on the circumstances.
National forests can be thought of as a public good
o they’re a good thing ecologically, they’re pretty to drive by and hike in, I
can enjoy them even if other people are enjoying them, and it’s hard to
exclude other people from getting their benefits.
On the other hand, 900 square feet in the middle of a city is a private good
o if I build an apartment there and live in it, that precludes you doing the
same; and as long as I get a door with a decent lock, I can keep you out.
Demsetz’s observation was that property rights over land developed among
Native Americans as the fur trade became more important economically
We can interpret this in terms of public and private goods.
Before the fur trade, land was pretty much a public good
o There was no shortage of animals, so hunting grounds were not
particularly rivalrous – I could hunt on your land, and still leave enough
game for you to hunt the next day
With the emergence of the fur trade came stronger incentives for hunting
o Fur-bearing animals became a valuable, so were hunted more, so became
scarce, so the land became a rivalrous good – the more I hunted, the less
luck you would have hunting on the same land
So the emergence of the fur trade led to a sort of transition of land from being a
public to a private good
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Efficiency would then suggest that at the same time, it should go from being
publicly owned (everyone could hunt on it) to being privately owned (one family
might have exclusive rights to hunt in a particular area)
Which is pretty much what happened
So the general principle is, private goods should be owned privately, and
public goods should be publicly provided/regulated
The book mentions the move in the 1990s toward deregulation/privitization as an
example of correcting a situation of private goods being publicly supplied
o services that did not involve externalities, and could therefore be supplied
by private industry, but for historical reasons were being run by the
government
o in the 1990s, there was a big movement to dismantle or sell off
government monopolies on trains, planes, and other services worldwide.
Cooter and Ulen also point out that in many cases, either type of ownership,
public or private, will involve some transaction costs, and the case can be made
for one or the other by considering the magnitude of these costs
Consider again the example of clean air
If there are lots of consumers affected by pollution from a factory, injunctive
relief is unlikely to work well, since transaction costs tend to be high when there
are lots of parties affected
However, there are still two possible ways to maintain clean air
One way is to grant property owners the right to clean air, but protected by
damages; so that a factory, if it felt it worthwhile, could choose to pollute and pay
damages
o The transaction cost here would be the legal cost of these lawsuits, or
pretrial negotiations
Alternatively, clean air could be viewed as a public good, and regulated by a
government agency
o This would involve administrative costs, and could run the risk of the level
of pollution not being the one that is socially optimal
We can argue for the efficiency of one system or the other by comparing the
magnitude of these transaction costs.
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So that gives a general answer to the question, What can be privately owned?
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The next question, How do I establish rights to something?
o we haven’t talked about this much yet
o there isn’t really a general theory behind it, since it can be seen just as an
extension of the question of what can be owned
o we will, however, come back and talk about it through some applications
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This leaves us with the question of, what can an owner do with his property?
o which we’ve already discussed some in the context of nuisance law
The principle laid out briefly in the textbook is the principle of maximum liberty
o maximum liberty suggests that owners can do anything with their property
that does not interfere with other peoples’ property or rights
o that is, you can do anything you like with your property as long as it
doesn’t impose an externality on anyone else
(They make the case that the common law approximates this.)
Of course, legislatures may pass laws that impose further restrictions on what
people can do with their property
In general, though, these laws are only efficient if the behavior they are restricting
causes an externality.
That wraps up what we want to say about property law in the abstract, that is, the
broad principles we want a property law system to adhere to
Starting next lecture, we’ll examine how this all works in practice, by examining
a number of applications.
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