Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2013 Lecture 7

Logistics • HW2 online, due in two weeks (Thurs Feb 28, 11:59 p.m.) • Midterm dates are set • First midterm is Monday March 4 • Second midterm is Monday April 8

Monday, we “tested the Coase Theorem” • Can UW undergrads reallocate poker chips efficiently? • (Cost me $173 to find out) • Lots to talk about!

Our experiment… • Take 1: Full Information (values on nametags) startingallocation efficientallocation actual final allocation fraction of potential gains realized red chip 12 red chip 10 purple chip purple chip 10 purple chip purple chip 8 red chip purple chip purple chip 8 purple chip purple chip 6 purple chip 6 4 purple chip 4 purple chip 2 purple chip 32 60 60 100%

Our experiment… • Take 2: Private Information (values hidden) startingallocation efficientallocation actual final allocation fraction of potential gains realized 10 red chip 8 purple chip red chip 8 purple chip purple chip 6 red chip purple chip 6 purple chip purple chip 4 purple chip purple chip 4 3 purple chip purple chip 3 purple chip 2 purple chip 24 48 35 11/24 = 46%

Our experiment… • Take 3: Uncertainty • All three chips got sold, at prices around $8 • Rolls were 4, 5, and 6, so buyers all made money… • …but trade would still have been efficient if they hadn’t • And we achieved 100% of gains from trade • Take 4: Asymmetric Information • Rolled 2, 3, and 6 • Once again, all three got sold, so 100% of gains were realized • But two of the three buyers lost money! • (I think if we repeated the experiment, trade would not occur that often…)

Conclusion • Coase works reasonably well, but not perfectly • Full info: 100% of gains achieved by socialist collective • Private info: 46% of gains, very significant deadweight loss • Uncertainty: 100% • Asymmetric info: 100%, but buyers lost money, I believe trade would have started to break down if we’d repeated

Considering the asymmetric-info case • To trade when die roll is 6, buyer must offer at least $12 • If he offers $12 or more, expect seller to always trade • But average value is 3 x 3.5 = 10.5 – buyer loses money • So we can never get trade when die roll is 6 • To trade when die roll is 5, buyer must offer at least $10 • Seller might trade when 1, 2, 3, 4, or 5, but not 6 • Average is 3 x 3 = 9 – buyer loses money • Can’t get trade when die roll is 5 • In this game: most efficient we can hope for is trade when die roll was 1, 2, or 3 • If buyer offers $6, expects seller to trade even when indifferent… • …then on average, buyer breaks even • In other games, asymmetric info can cause trade to break down completely

Comparing pure uncertainty to asymmetric information • Consider a seller in the last two cases • Your value = 2 x die roll, EV = $7.00 • If you know nothing… • Trade at some price between $7 and $10.50 • Expected payoff might be $8 or $9 • If you know value exactly… • Asymmetric information might stop you from being able to sell • If so, expected payoff is $7 • So information has negative value!

Transitioning back toproperty law…

Discussion question (old exam question, question by Alex Tabarrok at Marginal Revolution blog) In Virginia, the common law has long held that if a neighbor’s tree encroaches on your yard you may cut the branches as they cross the property line, but any damage the tree does to your property is your problem. Your neighbor can even sue if your pruning kills the tree. In 2007, the Virginia Supreme Court overruled this 70-year-old precedent, making it your neighbor’s duty to prune or cut down the tree if it is a “nuisance.” Which is better: the new rule or the old? What would the Coase Theorem say about the two rules?

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?

Calabresi and Melamed: Low TC  injunctions, high TC  damages • Low transaction costs: injunctive relief is cheap to implement, people can reallocate rights • High transaction costs: damages lead to better outcomes when parties can’t negotiate (polluting factory) • Agrees with our earlier principle • when TC are low, design the law to minimize transaction costs • when TC are high, design the law to minimize harm done from bargaining failures 12

Low transaction costs  injunctive relief • 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.” 13

So, do we buy it? • Coase relies on parties being able to negotiate privately if the right is not assigned efficiently • Low-TC case: injunctions more efficient, assuming bargaining works if “wrong” party is awarded the right • But does it work? • Paper by Farnsworth shows no bargaining after 20 nuisance cases • Our experiment showed various transaction costs that could be a problem: private information, uncertainty, asymmetric information 14

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) 15

What can an owner do with his property? • Principle 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

“Maximum liberty” vs. government’s right to regulate • Ruling a year 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”

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 to something else (here, 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

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

Dynamic games FIRM 1 (entrant) FIRM 2 (incumbent) Enter Don’t Enter (0, 30) Accommodate Fight (10, 10) (-10, -10) • A strategy is one player’s plan for what to do at each decision point he/she acts at • In this case: player 1’s possible strategies are “enter” and “don’t”, player 2’s are “accommodate” and “fight”

We can put payoffs from this game into a payoff matrix… Firm 2’s Action Accommodate Fight 10, 10 -10, -10 Enter Firm 1’s Action 0, 30 0, 30 Don’t Enter • We can look for equilibria like before • we find two: (Enter, Accommodate), and (Don’t Enter, Fight) • question: are both equilibria plausible? • sequential rationality 33

Dynamic games • In dynamic games, we look for Subgame Perfect Equilibria • players play best-responses in the game as a whole, but also in every branch of the game tree • We find Subgame Perfect Equilibria by backward induction • start at the bottom of the game tree and work our way up FIRM 1 (entrant) FIRM 2 (incumbent) Enter Don’t Enter (0, 30) Accommodate Fight (10, 10) (-10, -10)

The key assumption behind subgame perfect equilibrium: common knowledge of rationality • Firm 1 knows firm 2 is rational • So he knows that if he enters, firm 2 will do the rational thing – accommodate • So we enters, counting on firm 2 to accommodate • This is the idea of sequential rationality – the assumption that, whatever I do, I can count on the players moving after me to behave rationally in their own best interest

Econ 522 Economics of Law