Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 4.

Econ 522Economics of Law

Dan QuintSpring 2010Lecture 4

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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”)

Today… the Coase Theorem

Outline

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Coase

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Ronald Coase (1960), “The Problem of Social Cost”

In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency. So the initial allocation of rights

doesn’t matter for efficiency

However, it does matter for distribution And if there are transaction costs,

it may matter for efficiency too

The Coase Theorem

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Your car – worth $3,000 to you, $4,000 to me If I start out owning the car:

no reason for you to buy it, I end up with it efficient If you start out owning the car:

clear incentive for me to buy it, I end up with it efficient I’d rather start with it, you’d rather start with it… …but either way, we get to the efficient outcome

The key: lack of transaction costs

An example of the Coase Theorem

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“In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency”

You want to have a party next door to my apartment Think of “party rights” like an object I start off with “party rights” (right to be undisturbed):

You can buy them if they’re worth more to you (and your guests) You start off with party rights (right to have party):

I can buy them if quiet is worth more to me than party is to you Whoever starts with them, we still get to efficiency

Coase

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Example Coase uses: a rancher and a farmer

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Example Coase uses: a rancher and a farmer

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Three possibilities: Rancher builds fence around herd… $400 Farmer builds fence around crops… $200 Do nothing, live with damage… $0

If expected damage = $100…

If expected damage = $500…

Example: rancher and farmer

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Lots of examples from case law a building that blocked air currents from turning a windmill a building which cast a shadow over the swimming pool and

sunbathing area of a hotel next door a doctor next door to a confectioner a chemical manufacturer a house whose chimney no longer worked well after the neighbors

rebuilt their house to be taller

In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation

Other examples from Coase

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Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved.

In the case of the cattle and the crops, it is true that there would be no crop damage without the cattle. It is equally true that there would be no crop damage without the crops.The doctor’s work would not have been disturbed if the confectioner had not worked his machinery; but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place…

Quoting from Coase (p. 13):

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If we are to discuss the problem in terms of causation, both parties cause the damage.

If we are to attain an optimum allocation of resources, it is therefore desirable that both parties should take the harmful effects into account when deciding on their course of action.

It is one of the beauties of a smoothly operating pricing system that… the fall in the value of production due to the harmful effect would be a cost for both parties.

Quoting from Coase (p. 13):

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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…

…although it does matter for distribution…

…and it may matter for efficiency if there are transaction costs

So, summing up…

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Bargaining

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Example from before: Your car is worth $3,000 to you, and $4,000 to me Suppose 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

Some vocabulary about bargaining

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If I don’t buy the car from you… my payoff is 10,000 (my threat point) your payoff is 3,000 combined payoffs are 13,000

If 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 (or gains from cooperation) 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


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Threat points: 10,000 and 3,000

Gains from cooperation: 1,000

If gains from cooperation were divided equally… we’d each get 500 more than threat point my payoff would be 10,500, yours 3,500 Which means P = $3,500

(Coase doesn’t say gains will be divided equally, just that they’ll be divided in some way)


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Cows do $500 damage; fence around herd costs $400; fence around crops costs $200

Let’s go back to the rancher and farmer

-200-200Combined Payoffs

100-200Farmer’s Payoff

-3000Rancher’s Payoff (IF…)

2000Gains From Cooperation

0-200Farmer’s Threat Point

-4000Rancher’s Threat Point

Farmer’s RightsRancher’s Rights

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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

Relating Coase to general equilibrium/first welfare theorem

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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

Relating Coase to general equilibrium/first welfare theorem

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Demsetz

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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 1

10, 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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“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 (1967), “Toward a Theory of Property Rights”

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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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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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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 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…

So…

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TransactionCosts

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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

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 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.

Quoting Coase…

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“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

We can see the Coase Theorem as either a positive or negative result

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What AreTransaction Costs?

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What are transaction costs?

What do we do about them?

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Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 4.

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