Econ 522 Economics of Law Dan Quint Fall 2015 Lecture 5.

Econ 522Economics of Law

Dan Quint

Fall 2015

Lecture 5

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No class on Wednesday (Yom Kippur) G’mar Hatima Tovah

If you want to read ahead: Guido Calabresi and Douglas Melamed, “Property Rules, Liability

Rules, and Inalienability: One View of the Cathedral”

Reminders

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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…

…provided there are no transaction costs

Basically, allow people to bargain, and they’ll bargain to efficiency

Last week, we saw the Coase Theorem

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“There are two striking implications… that are true in a world of zero transaction costs.

The output mix that results when the exchange of property rights is allowed is efficient,

and the mix is independent of who is assigned ownership.

For example, the the efficient mix of civilians and military will result from transferable ownership no matter whether taxpayers must hire military volunteers or whether draftees must pay taxpayers to be excused from service.

For taxpayers will hire only those military (under the “buy-him-in” property right system) who would not pay to be exempted (under the “let-him-buy-his-way-out” system).”

Nice interpretation/example from a paper we’re talking about today

Harold Demsetz (1967), Toward A Theory of Property Rights

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Bargaining

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Let’s go back to ourrancher and farmer

Do nothing: $500 in crop

damage

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Rancher builds fence: $400

Farmer builds fence: $300

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Three possibilities Nobody builds a fence – $500 in damage Rancher builds fence – $400 cost Farmer builds fence – $300 cost

Suppose we’re in a farmer’s rights world Rancher is liable for any damage done by his herd

What does Coase predict will happen? They’ll bargain to efficient outcome Meaning, the farmer will build a fence (and the rancher will pay him) How much will he pay?


No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights

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Threat point – each side’s anticipated outcome if bargaining fails

“If we can’t agree to a deal and we go our separate ways, how well off am I?”

Negotiation textbooks call this your BATNA – “Best Alternative To a Negotiated Agreement” Also called outside option, or reservation utility

Deal has to make everyone better off than that!

Before bargaining:threat points


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Threat points

What happens to me if I don’t reach a deal with the rancher?Well, he’s liable for any crop damage……so there’s no reason for me to build a fence……and if there’s any damage, he’ll have to reimburse me……so if bargaining breaks down and I do nothing, my payoff is 0.That’s the best I can do on my own……so that’s my threat point.

What happens to me if I don’t reach a deal with the rancher?Well, he’s liable for any crop damage……so there’s no reason for me to build a fence……and if there’s any damage, he’ll have to reimburse me……so if bargaining breaks down and I do nothing, my payoff is 0.That’s the best I can do on my own……so that’s my threat point.


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Threat points

What happens if I don’t reach a deal with the farmer?He has no reason to build a fence……and I’m liable for crop damage……so my choices are to pay for $500 in damage……or to build a $400 fenceSo clearly, I’ll build a fenceSo my payoff if we don’t make a deal is –$400So that’s my threat point

What happens if I don’t reach a deal with the farmer?He has no reason to build a fence……and I’m liable for crop damage……so my choices are to pay for $500 in damage……or to build a $400 fenceSo clearly, I’ll build a fenceSo my payoff if we don’t make a deal is –$400So that’s my threat point


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So under a closed-range law…

The farmer’s threat point is 0, the rancher’s is –$400 Those are the payoffs that will happen if no agreement is reached

If a deal happens: total payoffs go up from –$400 to –$300 Farmer will build a fence (efficient outcome), rancher will pay him some

money

Cooperation causes total payoffs to go up by $100

So $100 is gains from cooperation (or gains from trade)

Gains from cooperationNo fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights

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Coase predicts negotiation will lead to efficiency So the gains from cooperation will be realized (The farmer will build a fence)

Both sides have to do at least as well as their threat point Otherwise, wouldn’t agree to deal

So rancher will pay farmer somewhere between $300 and $400 to build the fence But what if we want a more precise prediction?

So what will happen?No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights

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What if gains from cooperation were split evenly?

Threat points 0 and –400, gains of 100

Farmer’s payoff: 0 + ½ (100) = 50

Rancher’s payoff: –400 + ½ (100) = –350

How is this achieved? Rancher pays farmer $350 to build fence

So what will happen?No fence: $500 in harmRancher builds fence: $400Farmer builds fence: $300 Law: Farmer’s Rights

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If gains are split evenly…

-300Combined Payoffs

Farmer’s Payoff

Rancher’s Payoff (IF…)

100Gains From Cooperation

0Farmer’s Threat Point

-400Rancher’s Threat Point

Farmer’s Rights

–400 + ½ (100)

0 + ½ (100)

= –350

= 50


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If gains are split evenly…

-300-300Combined Payoffs

50-300Farmer’s Payoff

-3500Rancher’s Payoff (IF…)

1000Gains From Cooperation

0-300Farmer’s Threat Point

-4000Rancher’s Threat Point

Farmer’s RightsRancher’s Rights

=


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Let’s suppose… Having the party is worth $150 to you… …and a good night’s sleep is worth $100 to me So it’s efficient to have the party

If parties are allowed… No need for negotiation

If parties are not allowed… My threat point: 0 Your threat point: 0 Gains from cooperation: $50 If split evenly: payoffs are $25 and $25 Which requires you paying me $125 to have the party

One more example – you having a party next door to my house

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When are stronger property rights “worth it”?

1919

We motivated property law by looking at a game between two neighboring farmers

10 – c, 10 – c -5 – c, 12 – P

12 – P, -5 – c -P, -P

Farm Steal

Farm

Steal

Player 2

Pla

yer

110, 10 -5, 12

12, -5 0, 0

Farm Steal

Farm

Steal

Player 2

Pla

yer

1

MODIFIED GAMEORIGINAL GAME

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

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Incentive to overuse communal resources “Tragedy of the commons” – private property rights can fix this

Collective farming – incentive to shirk/freeride Again, private property rights fix this – for example… “It’s one of the ironies of American history that when the Pilgrims first arrived

at Plymouth rock they promptly set about creating a communist society. Of course, they were soon starving to death.

Fortunately… Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced. Bradford described the results…

“[Ending corn collectivism] had very good success, for it made all hands very industrious… The women now went willingly into the field, and took their little ones with them to set corn; which before would allege weakness and inability…””

- Marginal Revolution (blog post), “Thanksgiving Lessons”

Private property leads to better use of resources, by eliminating externalities

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“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.”

Harold Demsetz, “Toward a Theory of Property Rights”

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“A close relationship existed, both historically and geographically, between the development of private rights in land and the development of the commercial fur trade.

Because of the lack of control over hunting by others, it is in no person’s interest to invest in increasing or maintaining the stock of game. Overly intensive hunting takes place.

Before the fur trade became established, hunting was carried on primarily for purposes of food and the relatively few furs that were required for the hunter’s family. The externality was clearly present… but these external effects were of such small significance that it did not pay for anyone to take them into account.”


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“The advent of the fur trade had two immediate consequences. First, the value of furs to the Indians was increased considerably. Second, and as a result, the scale of hunting activity rose sharply. Both consequences must have increased considerably the importance of the externalities associated with free hunting. The property right system began to change…”

…even though property rights were not developing in the Southwest, where the commercial fur trade had not developed


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Private ownership of land among Native Americans Cost of administering private ownership: moderate Before fur trade…

externality was small, so gains from internalization were small gains < costs no private ownership of land


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Private ownership of land among Native Americans Cost of administering private ownership: moderate 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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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.

Friedman tells a similar story: “we owe civilization to the dogs”

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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.


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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


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Coase: if property rights are complete and tradable, we’ll always get efficiency can “fix” externalities by expanding property rights to cover

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

So…

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“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.”

Of course, Coase wasn’t actually ignoring costs…

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What are transaction costs, and how do we deal with them?

So…

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TransactionCosts

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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

What are transaction costs?

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Asymmetric information Akerloff (1970), “The Market for Lemons” – adverse selection

Bargaining costs come in many forms

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Quality of car

Proba-bility

Valueto Me

Valueto You

Great

Decent

Terrible

1/3

1/3

1/3

$6,000

$3,000

$0

$4,000

$2,000

$0

Average value to me: $3,000

Average value to me: $1,500

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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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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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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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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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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

Sources of transaction costs

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So, whatdo we do?

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No transaction costs / bargaining is easy

initial allocation of rights doesn’t matter for efficiency wherever they start, people will trade until efficiency is achieved

Significant transaction costs / bargaining is hard

initial allocation does matter, since trade may not occur (and is costly if it does)

This leads to two normative approaches we could take Minimize the cost of bargaining Minimize the need for bargaining

What we know so far…

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Design the law to minimize transaction costs “Structure the law so as to remove the impediments to private

agreements” Normative Coase “Lubricate” bargaining

Two normative approaches to property law

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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

Two normative approaches to property law

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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

Which approach should we use?

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When transaction costs are low, design the law to facilitate voluntary trade

When transaction costs are high, design the law to allocate rights efficiently whenever possible

So now we have one general principle we can use for designing property law

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For next week: Calabresi and Melamed

That’s it for today

Econ 522 Economics of Law Dan Quint Fall 2015 Lecture 5.

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Transcript of Econ 522 Economics of Law Dan Quint Fall 2015 Lecture 5.