Coase Theorem
The initial allocation of legal rights and liabilities
will not get in the way of the efficient allocation
of resources
• Where parties to a transaction are fully
informed about the consequences of alternatives
• Where parties to a transaction can bargain
freely and costlessly AND
• Where parties to a transaction can monitor and
enforce compliance with contracts costlessly
That Means:
• It doesn’t matter who owns what, the
person who can use IT best (measured in
terms of willingness and ability to pay) will
end up with IT
• It doesn’t matter who is responsible for the
design, manufacture, or sale of a product,
its attributes will be efficient
It Doesn’t Mean:
That the distribution of income or wealth will
be the same regardless of the prior
distribution of rights and liabilities
(The distribution of income or wealth after a
transaction depends on the distribution of
wealth (assets or rights minus liabilities or
obligations) prior to the transaction)
Solution
Annualized Cost of Spark arrester = $3000
Annualized Cost of Fire Damage = $4500
Annualized Cost of Spark arrester = $3000
Annualized Cost of Fire Damage = $1500
Does it Matter who is Liable for
damages?
NO
What Happens if Railroad is Liable?
• If fire damage
= $4500,
Railroad Co.
buys spark
arrester
• If fire damage
= $1500,
Railroad Co.
pays damages
to farmers
What Happens if Farmer is
Liable?
• If fire damage
= $4500,
farmer buys
spark arrester
for Railroad
Co.
• If fire damage
= $1500,
farmer stands
ready to put
out fires
caused by
train
Moral Hazard
(term comes from insurance industry)
The WASTEFUL behavior induced when people
do not bear the full consequences of their actions
IN THE TRAIN/FARMER EXAMPLE, WHICH
ASSIGNMENT OF LIABILITY WAS MORE
LIKELY TO CREATE A MORAL HAZARD?
Farmer or Railroad Co.?
Asymmetric Information Costs
• Search cost -- the cost of obtaining full
knowledge of the THING being transacted
including the consequences of its use and its
alternatives
• Bargaining cost -- the cost of reaching a
mutually satisfactory contract
• Monitoring and enforcement costs -- the cost of
insuring compliance with contractual terms
In the information asymmetries, market incentives together with
either public provision of information or — in the case of
information asymmetries — reassignment of liability, public
certification, or enforced disclosure will often produce more
efficient outcomes than will a regulatory program that restricts
the range of goods and services made available, enforces
maintenance standards, or establishes maximum levels of
exposure to health and safety hazards.
Where participants in private market transactions err only
because information is absent, public provision of information will
be more efficient than regulation. This follows from the
observation that public provision of information can meet
economic objectives without removing alternatives from the
market that some consumers or workers would prefer.
Kinds of Product Liability
(all theories of product liability require the injury to be
related to product use -- reflect changing reality about
who is best located to make knowlegeable choices about
net benefits)
• Caveat Emptor
• Negligence
• Strict Liability
– Voluntary and knowing assumption of the risk
(known and avoidable danger)
– Contributory negligence (not just misuse)
– Disclaimers
• Absolute Liability
Damages
(no right without a remedy)
• Economic Losses (replacement cost, out
of pocket expenses)
• Compensation for Pain and Suffering
• Punitive Damages
Regulatory Optimum