Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2017 Lecture 7

Monday, we “tested the Coase Theorem” • Can UW undergrads reallocate poker chips efficiently? • (Cost me $124 to find out) • What happened?

Our experiment… • Take 1: Full Information (values on nametags) startingallocation efficientallocation actual final allocation fraction of potential gains realized purple chip 12 red chip 10 purple chip purple chip 10 purple chip purple chip red chip 8 red chip purple chip 8 purple chip purple chip 6 purple chip 6 4 purple chip 4 purple chip 2 purple chip 32 60 54 22/28 = 79%

Our experiment… • Take 2: Private Information (values hidden) startingallocation efficientallocation actual final allocation fraction of potential gains realized red chip 10 red chip purple chip 8 purple chip 8 purple chip purple chip 6 red chip purple chip purple chip 6 purple chip purple chip 4 purple chip 4 3 purple chip 3 purple chip 2 purple chip 24 48 46 22/24 = 92%

Our experiment… • Take 3: Uncertainty • Rolled 3 – chip worth 6 to seller, 9 to buyer • Chip traded • So we achieved 100% of gains from trade! • (Seller accepted less than expected value) • Take 4: Asymmetric Information • Rolled 5 – worth 10 to seller, 15 to buyer • Chip traded (for 11), so we achieved all the gains! • (Big leap of faith for buyer to pay 11, but it worked out)

Conclusion • Coase seems to work pretty well – even when there are potential information problems! • Full info: 79% of gains achieved • Private info: 92% of gains • Uncertainty: 100% • Asymmetric info: 100% • But that’s in a pretty idealized environment

Question to ponder • “Recharge shop” owners in India are saving women’s numbers when they add mobile minutes, selling them to harassers • What would the Coase Theorem say about efficient “ownership” of knowledge of someone’s phone number? • Does Coase apply here? Why/why not? • What remedy would make sense here?

Monday: starting thinking about details of efficient property law system what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

Monday: starting thinking about details of efficient property law system • Calabresi/Melamed: three types of remedies • Injunctive relief (property rule) – violations prohibited without prior permission, punished severely, but tradable • Damages (liability rule) – violations compensated • Inalienability – violations punished, not tradable • Inalienability… • Might make sense when allocation involves large externalities that can’t be overcome • Might be a product of governmental paternalism… • …or legislator (or voter) repugnance 8

Monday: starting thinking about details of efficient property law system • When transaction costs are low, use injunctive relief • Either rule will lead to efficient allocation (Coase)… • …but injunctions are cheaper to implement (court doesn’t have to assess level of harm) • When transaction costs are high, use damages • If bargaining is impossible, damages  more efficient outcomes • (Example: polluter can choose to pollute and pay when that’s more efficient than preventing the damage) • Agrees with principle from last week • TC low: design law to facilitate trade (normative Coase) • TC high: design law to not rely on bargaining (normative Hobbes) 9

Onward! what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

Public versus Private Goods Private Goods • rivalrous – one’s consumption precludes another • excludable – technologically possible to prevent consumption • example: apple Public Goods • non-rivalrous • non-excludable • examples • defense against nuclear attack • infrastructure (roads, bridges) • parks, clean air, large fireworks displays

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited • When public goods are privately owned, they tend to be underprovided/undersupplied

Public versus Private Goods • When private goods are owned publicly, they tend to be overutilized/overexploited • When public goods are privately owned, they tend to be underprovided/undersupplied • Efficiency suggests private goods should be privately owned, and public goods should be publicly provided/regulated

This also accords with the principle from last week • Transaction costs low facilitate voluntary trade • Private goods – low transaction costs • Private ownership facilitates trade • Transaction costs high  allocate rights efficiently • Public goods – high transaction costs • Public provision/regulation required to get efficient amount

A different view: transaction costs • Clean air • Large number of people affected  transaction costs high  injunctive relief unlikely to work well • Still two options • One: give property owners right to clean air, protected by damages • Two: public regulation • Argue for one or the other by comparing costs of each • Damages: costs are legal cost of lawsuits or pretrial negotiations • Regulation: administrative costs, error costs if level is not chosen correctly 17

How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

What can an owner do with his/her property? • For efficiency: principle of maximum liberty • Owners can do whatever they like with their property… • …provided that doesn’t interfere with others’ property or rights • That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else • Textbook: common law often approximates rule of maximum liberty • But does it really? • What about bans on repugnant markets? • And…

“Maximum liberty” vs. government’s right to regulate • Ruling a few years ago by a Dane County judge • Plaintiffs argued they had a “fundamental right to own a cow, and to use their cows in a manner that does not cause harm to a third party” • Judge responded: “Plaintiffs do not have a fundamental right to own and use a dairy cow or a dairy herd Plaintiffs do not have a fundamental right to consume the milk from their own cow Plaintiffs do not have a fundamental right to board their cow at the farm of a farmer The private contract does not fall outside the scope of the States’ police power Plaintiffs do not have a fundamental right to produce and consume the foods of their choice DATCP has jurisdiction to regulate the Plaintiffs’ conduct”

How do we design an efficient property law system? what can be privately owned? what can an owner do? how are property rights established? what remedies are given?

Fugitive property • Hammonds v. Central Kentucky Natural Gas Co. • Central Kentucky leased land lying above natural gas deposits • Geological dome lay partly under Hammonds’ land • Central Kentucky drilled down and extracted the gas • Hammonds sued, claiming some of the gas was his • (Anybody see “There Will Be Blood”?) Hammonds Central KY

Two principles for establishing ownership • First Possession • nobody owns fugitive property until someone possesses it • first to “capture” a resource owns it • Central Kentucky would own all the gas • Tied Ownership • ownership of fugitive property tied (linked) to something else – here, ownership of the surface • so ownership already determined before resource is extracted • Hammonds would own some of the gas, since under his land • principle of accession – a new thing is owned by the owner of the proximate or prominent property

First Possession versus Tied Ownership • First Possession • simpler to apply – easy to determine who possessed property first • incentive to invest too much to early in order to establish ownership • example: $100 of gas, two companies drilling fast or slow • drilling slowly costs $5, drilling fast costs $25 • drill same speed  each gets half the gas, one drills fast  75/25 Firm 2 Slow Fast 45, 45 20, 50 Slow Firm 1 50, 20 25, 25 Fast

First Possession versus Tied Ownership • First Possession • simpler to apply – easy to determine who possessed property first • incentive to invest too much to early in order to establish ownership • Tied Ownership • encourages efficient use of the resource • but, difficulty of establishing and verifying ownership rights Firm 2 Slow Fast 45, 45 45, 25 Slow Firm 1 25, 45 25, 25 Fast

This brings us to the following tradeoff: Rules that link ownership to possession have the advantage of being easy to administer, and the disadvantage of providing incentives for uneconomic investment in possessory acts. Rules that allow ownership without possession have the advantage of avoiding preemptive investment and the disadvantage of being costly to administer.

We’ve already seen two examples of this • “Fast fish/loose fish” and “the guy who kills a fox, owns it” are examples of a first possession rule • You can’t own a resource until you physically possess it • “Iron holds the whale” and “the guy chasing a fox owns it” are examples of a tied ownership rule • You can establish ownership of something before you actually possess it • (A harpoon, or chasing a fox, gives you a right to it) • More complicated/costly to enforce • “if the first seeing, starting, or pursuing such animals… should afford the basis of actions against others for intercepting and killing them, it would prove a fertile source of quarrels and litigation” • But avoids incentive to poach someone else’s resource

Another nice historical example: the Homestead Act of 1862 • Meant to encourage settlement of the Western U.S. • Citizens could acquire 160 acres of land for free, provided • head of a family or 21 years old • “for the purpose of actual cultivation, and not… for the use or benefit of someone else” • had to live on the claim for 6 months and make “suitable” improvements • Basically a first possession rule for land – by living on the land, you gained ownership of it • Friedman: caused people to spend inefficiently much to gain ownership of the land

Friedman on the Homestead Act of 1862 “The year is 1862; the piece of land we are considering is… too far from railroads, feed stores, and other people to be cultivated at a profit. …The efficient rule would be to start farming the land the first year that doing so becomes profitable, say 1890. But if you set out to homestead the land in 1890, you will get an unpleasant surprise: someone else is already there. …If you want to get the land you will have to come early. By farming it at a loss for a few years you can acquire the right to farm it thereafter at a profit.

Friedman on the Homestead Act of 1862 How early will you have to come? Assume the value of the land in 1890 is going to be $20,000, representing the present value of the profit that can be made by farming it from then on. Further assume that the loss from farming it earlier than that is $1,000 a year. If you try to homestead it in 1880, you again find the land already taken. Someone who homesteads in 1880 pays $10,000 in losses for $20,000 in real estate – not as good as getting it for free, but still an attractive deal. …The land will be claimed about 1870, just early enough so that the losses in the early years balance the later gains. It follows that the effect of the Homestead Act was to wipe out, in costs of premature farming, a large part of the land value of the United States.”

So, what does an efficient property law system look like? • What things can be privately owned? • Private goods are privately owned, public goods are publicly provided • What can owners do with their property? • Maximum liberty • How are property rights established? • (Tradeoff between first possession and tied ownership; more examples to come) • What remedies are given? • Injunctions when transaction costs are low; damages when transaction costs are high

Next up • Next up: some applications of property law • But first, one more tool…

SequentialRationality

Dynamic games and sequential rationality • Game theory we’ve seen so far: static games • “everything happens at once” • (nobody observes another player’s move before deciding how to act) • Dynamic games • one player moves first • second player learns what first player did, and then moves

Let’s go back to a game we’ve seen – the Battle of the Sexes Player 2 Ballgame Opera 6, 3 0, 0 Ballgame Player 1 0, 0 3, 6 Opera • Now change the game so that player 1 moves first • Player 1 goes somewhere • Player 2 learns what 1 did, then decides where to go 35

Dynamic games are typically shown as “game trees” PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) • A strategy is one player’s plan for what to do at each decision point he/she acts at • Player 1: “Ballgame” or “Opera” • Player 2’s strategy is more complicated – can depend on P1’s choice

We can expand the matrix to accommodate Player 2’s additional options Player 2 Ballgame,Ballgame Ballgame,Opera Opera,Ballgame Opera,Opera 6, 3 6, 3 0, 0 0, 0 Ballgame Player 1 0, 0 3, 6 0, 0 3, 6 Opera • Player 2 has four options • “Go to the ballgame no matter what” • “Go to the ballgame if P1 went to the ballgame, otherwise opera” • “Opera if P1 went to the ballgame, otherwise ballgame” • “Opera no matter what” 37

We can solve this game for equilibrium in the “usual” way Player 2 Ballgame,Ballgame Ballgame,Opera Opera,Ballgame Opera,Opera 6, 3 6, 3 0, 0 0, 0 Ballgame Player 1 0, 0 3, 6 0, 0 3, 6 Opera • Three equilibria: • 1 goes to ballgame, 2 plays “ballgame no matter what” • 1 goes to ballgame, 2 plays “go wherever 1 went” • 1 goes to opera, 2 plays “opera no matter what” • Are all of these “reasonable”? 38

Are all these equilibria “reasonable”? • Consider the equilibrium where • player 2 plans to go to the opera no matter what • player 1 therefore goes to the opera • Player 1 might wonder… • “Suppose I changed my mind and went to the ballgame. • Once I’m there, player 2 has to choose between sticking to the plan, going to the opera, and getting 0… • …versus following me to the ballgame and getting 3. • If player 2 is rational and I go to the ballgame, she should follow me there, and I’ll end up with a payoff of 6!”

Sequential rationality • Sequential rationality is when a player can count on the other players to behave rationally from that point forward • Similar to “dynamic consistency” (macro) • When an equilibrium satisfies sequential rationality, we callit a Subgame-Perfect Equilibrium • Players play best-responses both in the game as a whole, and in each “subgame,” or part of the game • Rules out the opera-opera equilibrium: in the subgame where P1 had already gone to the ballgame, P2 wasn’t playing a best-response • In fact, P2 only has one strategy that is sequentially rational: do whatever player 1 did!

Subgame Perfect Equilibria are found by Backward Induction PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) • Start at the “bottom,” solve for what P2 would do at each point • If P2 is rational and P1 knows it, P1 can infer what payoff he would get from each move • Now figure out what P1 would do, given those payoffs

Subgame Perfect Equilibria are found by Backward Induction PLAYER 1 Ballgame Opera PLAYER 2 PLAYER 2 Ballgame Opera Ballgame Opera (6, 3) (0, 0) (0, 0) (3, 6) • This game has a unique subgame-perfect equilibrium • Player 1 plays Ballgame • Player 2 plays Ballgame if 1 plays Ballgame, Opera if 1 plays Opera • “Most” dynamic games have just one SPE

Moving first can be good or bad, depending on the game • Battle of the sexes: moving first is good • You know your partner will accommodate whatever you do… • …so you get your first choice • Some games: being able to “commit” to a decision, while your opponent still has to decide, can be good! • (Another example: entry game) • Scissors-paper-rock: moving first is terrible • You always lose • Some games: reacting to your opponent’s move is good!

When we look at dynamic games, we’ll always look only at subgame-perfect equilibrium • Key assumption: common knowledge of rationality • Player 1 knows player 2 is rational… • …so whatever he does, she’ll do what’s best for her… • …so player 1 can confidently go to the ballgame • This is the key to sequential rationality • The assumption that, whatever happens first, players will continue to act rationally in their own best interest • Which means we can “solve the game” from the end, and figure out the beginning players’ optimal moves • (Backward induction has been used to solve checkers in 2007 – it’s a draw – and will eventually solve chess…)

Monday, we’ll start in on some particular applications of property law

Econ 522 Economics of Law