Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 5

Logistics • HW1 online – due Tues October 6 • First midterm – Tues October 13 (in class) • covers all material through end of Property Law • sample questions online • No lecture Thurs October 1 • If you didn’t get my email on Tuesday…

Last lecture… • Coase: in the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency • or, if property rights are comprehensive enough, we can overcome externalities • Demsetz: yes, but more comprehensive property rights are more costly to administer • will only develop when benefits outweigh costs

Last lecture… Sources of Transaction Costs: • Search costs • Bargaining costs • Asymmetric information • Threat points being private information or uncertain • Large number of buyers or sellers • Hostility • Enforcement costs

Last lecture… • Coase Theorem: transaction costs  efficiency • Normative Coase: design the law to minimize transaction costs • Normative Hobbes: design the law to minimize losses from breakdown in bargaining (or, roughly, allocate rights efficiently) • Transaction costs vs. information costs • trans costs low, info costs high  minimize transaction costs (“lubricate private bargaining”) • trans costs high, info costs low  allocate rights efficiently (make private bargaining unnecessary)

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

Calabresi and Melamed treat property and liability under a common framework • Calabresi and Melamed (1972), Property Rules, Liability Rules, and Inalienability: One View of the Cathedral • Liability • Is the rancher liable for the damage done by his herd? • Property • Does the farmer’s right to his property include the right to be free from trespassing cows? • Entitlements • Is the farmer entitledto land free from trespassing animals? • Or is the rancher entitledto the natural actions of his cattle?

Three possible ways to protect an entitlement • Property rule / injunctive relief • Violation of my entitlement is punished as a crime • Injunction: court order clarifying a right and specifically barring any future violation

Three possible ways to protect an entitlement • Property rule / injunctive relief • Violation of my entitlement is punished as a crime • Injunction: court order clarifying a right and specifically barring any future violation • Liability rule / damages • Damages are a payment to a victim to compensate for actual damage done • Better when prior negotiation is impossible • Inalienability

Comparing property/injunctive relief to liability/damages rule • Injuree (person whose entitlement is violated) always prefers a property rule • Injurer always prefers a damages rule • Why? • Punishment for violating a property rule is severe • If the two sides need to negotiate to trade the right, injurer’s threat point is lower • Even if both rules eventually lead to the same outcome, injurer may have to pay more

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 Comparing injunctive relief todamages – example • Electric company E emits smoke, dirties the laundry at a laundromat L next door • E earns profits of 1,000 • Without smoke, L earns profits of 300 • Smoke reduces L’s profits from 300 to 100 • E could stop polluting at cost 500 • L could prevent the damage at cost 100

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 First, we consider thenon-cooperative outcomes • Polluter’s Rights (no remedy) • E earns 1,000 • L installs filters, earns 300 – 100 = 200 • Laundromat has right to damages • E earns 1,000, pays damages of 200  800 • L earns 100, gets damages of 200  300 • Laundromat gets injunction • E installs scrubbers, earns 1,000 – 500 = 500 • L earns 300

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 Noncooperative payoffs Polluter’s Rights Damages Injunction E payoff(non-coop) 1,000 800 500 L payoff(non-coop) 200 300 300 Combined payoff (non-coop) 1,200 1,100 800

E profits = 1,000L profits = 300  100E prevention = 500L prevention = 100 What about with bargaining? Polluter’s Rights Damages Injunction E payoff(non-coop) 1,000 800 500 L payoff(non-coop) 200 300 300 Combined payoff (non-coop) 1,200 1,100 800 Gains from Trade 0 100 400 E payoff (coop) 1,000 850 700 800 + ½ (100) 500 + ½ (400) L payoff (coop) 200 350 500 300 + ½ (100) 300 + ½ (400) Combined 1,200 1,200 1,200

How do we choose between the rules? • In this case… • Polluter’s rights > damages > injunction when there is no bargaining • All three equally efficient when there is bargaining • Normative Hobbes: allocate rights efficiently to begin with • Polluter’s rights in this case, no reason to believe this more generally • Normative Coase: just work to lower transaction costs, let people negotiate when they need to • So what do we do?

How do we choose between the rules? • Injunctions are cheaper for court to implement • No need to calculate exact amount of damage done • Damages are more efficient when private bargaining fails • Leads Calabresi and Melamed to the following conclusion: When transaction costs are high, a liability rule (damages) is more efficient When transaction costs are low, a property rule (injunctive relief) is more efficient

So that’s our answer: • Calabresi and Melamed When transaction costs are high, a liability rule (damages) is more efficient When transaction costs are low, a property rule (injunctive relief) is more efficient • But why are damages more efficient when bargaining fails? • Under damages rule, injurer has two choices: prevent the damage, or pay cost afterwards • Under injunction, injurer has only one choice: prevent the damage • Injuree is compensated, so doesn’t matter to him • So whichever is cheaper for injurer, is more efficient

High transaction costs  damagesLow transaction costs  injunctive relief “Private bargaining is unlikely to succeed in disputes involving a large number of geographically dispersed strangers because communication costs are high, monitoring is costly, and strategic behavior is likely to occur. Large numbers of land owners are typically affected by nuisances, such as air pollution or the stench from a feedlot. In these cases, damages are the preferred remedy. On the other hand, property disputes generally involve a small number of parties who live near each other and can monitor each others’ behavior easily after reaching a deal; so injunctive relief is usually used in these cases.” (Cooter and Ulen)

A different view of the high-transaction-costs case… “When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more and it does not know how much either party values it absolutely. Conversely, the court should protect a right by a damages remedy if it knows how much one of the parties values the right absolutely and it does not know which party values it relatively more.” (Cooter and Ulen)

Low transaction costs  injunctive relief • Cheaper for the court to administer • With low transaction costs, we expect parties to negotiate privately if the right is not assigned efficiently • But… do they really? • Ward Farnsworth (1999), Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside The Cathedral • 20 nuisance cases: no bargaining after judgment “In almost every case the lawyers said that acrimony between the parties was an important obstacle to bargaining… Frequently the parties were not on speaking terms... …The second recurring obstacle involves the parties’ disinclination to think of the rights at stake… as readily commensurable with cash.”

Finally, inalienability • Inalienability: when an entitlement is not transferable or saleable

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

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

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 property? • Priniciple of maximum liberty • Owners can do whatever they like with their property, provided it does not interfere with other’ property or rights • That is, you can do anything you like so long as it doesn’t impose an externality (nuisance) on anyone else

That’s it for today • Up next: applications • (Textbook ch. 5)

Econ 522 Economics of Law