Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2017 Lecture 4

Reminder • HW1 due midnight Thursday via Learn@UW • If you want to read ahead: • Harold Demsetz, “Toward a Theory of Property Rights”

So far, we have… • Defined efficiency • Maximizing total surplus achieved by everyone in society… • …with value measured by willingness-to-pay • Asked whether efficiency is a good normative goal for a legal system • Posner: yes, because ex ante (before we knew which part we would play), we’d all agree to efficient rules • Cooter and Ulen: yes, because even if society has other goals in mind, such as redistribution, it’s better to make the law efficient and achieve redistribution through taxes

So far, we have… • Reviewed some basic game theory • Static games, Nash equilibrium • Motivated an interest in property law • With property rights: we’ll inevitably have some conflicts between different peoples’ rights to their property • But without property rights: tragedy of the commons, incentives to steal rather than do productive work • Up next: how should we design property rights to achieve efficient outcomes?

But first, an open discussion question • We asked whether efficiency is a good normative goal for a legal system • What are other plausible normative goals for a legal system? • When would you expect them to agree with, or conflict with, efficiency?

Property Law 5

How do we design property law to achieve efficient outcomes? 6

Foxes

One early, “classic” property law case • Pierson v. Post (NY Supreme Court, 1805) • Lodowick Post organized a fox hunt, was chasinga fox • Jesse Pierson appeared “out of nowhere,” killedthe fox and took it • Post sued to get the fox back • Lower court sided with Post; Pierson appealed to NY Supreme Court • Question: when do you own an animal? 8

One early, “classic” property law case • Court ruled for Pierson (the one who killed the fox) • “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” • (Also: just because an action is “uncourteous or unkind” does not make it illegal) • Dissenting opinion: a fox is a “wild and noxious beast,” and killing foxes is “meritorious and of public benefit” • Post should own the fox, in order to encourage fox hunting 9

Same tradeoff we saw earlier: Pierson gets the fox • simpler rule (finders keepers) • easier to implement • fewer disputes Post gets the fox • more efficient incentives • (stronger incentive to pursue animals that may be hard to catch) • Just like Fast Fish/Loose Fish vs Iron Holds The Whale • Fast Fish/Loose Fish is the simpler rule, leads to fewer disputes • Iron Holds the Whale is more complicated, but is necessary with whales where hunting them the old-fashioned way is too dangerous 10

This suggests it matters quite a bit who we award the fox to • Not just to Pierson and Post, who both want it… • …but for efficiency • And this brings us to… 11

Coase

How should property rights be allocated to achieve efficiency? • Coase’s surprising answer: it doesn’t matter • (Under certain conditions)

The Coase Theorem • Ronald Coase (1960), “The Problem of Social Cost” • In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency. • It doesn’t matter how rights are allocatedinitially… • …because if they’re allocated inefficientlyat first, they can always be sold/traded… • so the allocation will end up efficient anyway • Initial allocation does matter for distribution, though • And if there are transaction costs, may matter for efficiency too Ronald Coase1910-2013

Example of Coase: you have a car worth $3,000 to you, $4,000 to me • Obviously, efficient for me to own it… • …but we don’t need the law to give me the car • 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 • Regardless of who owns the car at first, we get to the efficient outcome • I’d rather start out with the car – so I don’t have to pay you for it • You’d rather start out with it – so you end up with more money • Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. • And that doesn’t depend on who starts with it.

Example of Coase: you have a car worth $3,000 to you, $4,000 to me • Obviously, efficient for me to own it… • …but we don’t need the law to give me the car • 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 • Regardless of who owns the car at first, we get to the efficient outcome • I’d rather start out with the car – so I don’t have to pay you for it • You’d rather start out with it – so you end up with more money • Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end. • And that doesn’t depend on who starts with it. • The key: lack of transaction costs

A better example: you want to have a party in the house next door to mine • If it’s efficient for you to have the party… • Your benefit from having the party is greater than my benefit from a good night’s sleep • If you start out with the right to have the party, no problem • If I start out with the right to quiet, you can pay me for the right to have the party • If it’s efficient for you not to have the party… • Good night sleep is worth more to me • If I have right to silence, no problem • If you have right to party, I can pay you not to have it • The point: either way, we achieve efficiency • If it’s efficient to have the party, you have the party • If it’s efficient not to, you don’t • Regardless of who started off with the right

The conditions for this to hold • Property rights have to be well-defined… • It must be clear on who has what rights to start with, so we know the starting point for negotiations • …and tradable… • We need to be allowed to sell/transfer/reallocate rights if we want • …and there can’t be transaction costs • It can’t be difficult or costly for us to buy/sell the right • So, the Coase Theorem: In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.

A couple recent real-world examples source: http://www.thestar.com/yourtoronto/education/2013/09/19/u_of_t_students_trade_cash_for_seats_in_full_classes.html#sthash.ukMK1JYp.dpufhttp://awfulannouncing.com/2016/report-fox-and-espn-will-pay-big-12-to-not-expand.html?utm_source=dlvr.it&utm_medium=twitter

Coase’s example: a rancher and a farmer

Rancher’s versus farmer’s rights • English common law: “closed range” or “fencing-in”(or “farmer’s rights”) • Ranchers have responsibility to control their cattle • Rancher must pay for any damage done by his herd • Much of the U.S. at various times: “open range” or “fencing-out” (or “rancher’s rights”) • Rancher can let his cattle roam free • Not liable for damage they do to farmer’s crops (unless farmer had a good fence and they broke through anyway) • Which rule is more efficient?

Open range versus closed range

Coase: either law will lead to efficiency • If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd… • Under open range law, that’s what he’ll do • Under closed range law, rancher can pay farmer to build fence • If smaller herd is more efficient, farmer can pay rancher to keep fewer cattle • Coase: • Whatever is the efficient combination of cattle, crops, fences, etc.… • …the rancher and farmer will negotiate to that efficient outcome, regardless of which law is in place… • …as long as the rights are well-defined and tradable and there are no transaction costs

Note that there’s no sense of “blame” here • Pigovian tax (Arthur Pigou) • Penalize firms for causing negative externalities • Requires us to “blame” one party • Coase: doesn’t matter who is “causing” the harm • “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.” • Coase isn’t worried about “justice”, just efficiency • Doesn’t matter if a polluter is actually charged for polluting… • …or is allowed to pollute, but could be bribed to not pollute • Either way, without transaction costs, we’ll end up getting the efficient amount of pollution!

Rancher and farmer: numerical example • Three possibilities: • Rancher builds fence around herd… costs $400 • Farmer builds fence around crops… costs $200 • Do nothing, live with damage… costs nothing • If expected crop damage = $100 • Open range: farmer lives with damage rather than building fence • Closed range: rancher pays for damage rather than fence • If expected crop damage = $500 • Open range: farmer builds fence – efficient • Coase: closed range: rancher pays farmer to build fence • So efficient outcome under either rule

Other examples from Coase • 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

Quoting from Coase (p. 9): The court’s decision established that the doctor had the right to prevent the confectioner from using his machinery. But, of course, it would have been possible to modify the arrangements envisaged in the legal ruling by means of a bargain between the two parties. The doctor would have been willing to waive his right and allow the machinery to continue in operation if the confectioner would have paid him a sum of money which was greater than the loss of income which he would suffer from having to move to a more costly or less convenient location or from having to curtail his activities… The confectioner would have been willing to do this if the amount he would have to pay the doctor was less than the fall in income he would suffer if he had to change his mode of operation at this location, abandon his operation or move… The solution of the problem depends essentially on whether the continued use of the machinery adds more to the confectioner’s income than it subtracts from the doctor’s.

Quoting from Coase (p. 13): 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): 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.

What does Coase mean by “a cost for both parties”? • If the cheapest alternative is for the farmer to build a fence for $200… • The cost to build a fence is $200 • But the cost to not build a fence is more than $200 – since under a closed-range law, the farmer could ask the rancher for more than $200 to build the fence • “Opportunity cost”

So, summing up… • 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 • (But if there are transaction costs, then the initial allocation can matter for efficiency… • …and it will always matter for distribution)

Back to Foxes

Doesn’t Coase make Pierson v Post irrelevant? • Coase seems to say: for efficiency, it doesn’t matter who starts off with the right to the fox • If Post values it more, he can buy it from Pierson, or vice versa • Seems to imply: one rule is just as good as the other, as long as we all know what the rule is • So why does Pierson v Post matter? • Transaction costs! • Majority: if Post gets the fox back, “it would prove a fertile course of quarrels and litigation” – the ensuing lawsuits would be costly • Dissent: killing foxes is a good thing (externality), so lots of people benefit – so hard to get efficient amount of fox hunting through bargaining

Transaction costs • Coase: “in the absence of transaction costs, if property rights are well-defined and tradable, 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

Quoting Coase… “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.

We can see the Coase Theorem as either a positive or negative result • “In the absence of transaction costs, if property rights are well-defined and tradable, 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

Many externalities can be thought of as missing property rights • Overfishing in communal lake? • It’s because property rights over those fish aren’t well-defined • Firm polluting too much? • It’s because property rights over clean air aren’t well-defined • So one solution… • Make property rights complete enough to cover “everything,” and tradable, and use the law to minimize transaction costs… • …Then Coase kicks in and we get efficiency! (Booya!) • Why not do this? Costs.

Relating Coase to general equilibrium/first welfare theorem • 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

Nice interpretation/example from the paper we’re talking about next “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).” Harold Demsetz (1967), Toward A Theory of Property Rights 40

That’s it for today • HW1 due (online submission) midnight Thursday • For Wednesday • Demsetz, “Toward a Theory of Property Rights”

Econ 522 Economics of Law