Econ 522 Economics of Law

Dan Quint Spring 2014 Lecture 7

Monday, we “tested the Coase Theorem”  Can UW undergrads reallocate poker chips efficiently?

 (Cost me $161 to find out)  What happened?

1

Our experiment…  Take 1: Full Information (values on nametags) 12 10 4 2 6 4 10 8 8 6

starting allocation

red chip purple chip purple chip purple chip purple chip 32

efficient allocation

red chip purple chip purple chip purple chip purple chip 60

actual final allocation

purple chip red chip purple chip purple chip purple chip

fraction of potential gains realized

58

26/28 =

93%

2

Our experiment…  Take 2: Private Information (values hidden) 10 8 3 2 4 3 6 4 8 6

starting allocation

red chip purple chip purple chip purple chip purple chip 24

efficient allocation

red chip purple chip purple chip purple chip purple chip 48

actual final allocation

purple chip red chip purple chip purple chip purple chip

fraction of potential gains realized

46

22/24 =

92%

3

Our experiment…  Take 3: Uncertainty     All three chips got sold, at prices around $8 Rolls were 1, 3, and 6, so one buyer lost money… …but trade was still efficient And we achieved 100% of gains from trade  Take 4: Asymmetric Information  Rolled 3, 3, and 6   One of the 3s got traded, for $6 So we achieved 3/(3+3+6) = 25% of gains from trade 4

Conclusion  Coase seems to work pretty well, except when there’s asymmetric information/adverse selection  Full info:

93%

of gains achieved  Private info:

92%

of gains  Uncertainty:

100%

 Asymmetric info:

25%

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Example of Coasian bargaining I found last semester source: http://www.thestar.com/yourtoronto/education/2013/09/19/u_of_t_students_trade_cash_for_seats_in_full_classes.html#sthash.ukMK1JYp.dpuf

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One other observation: information can be bad for the person who has it  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  If you know value exactly…  Asymmetric information might mean you can’t trade at all  So expected payoff would be $7  So expected payoff is higher if you don’t have information, or

the value of the information is negative

!

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Back to property law… 8

Four questions we need to answer what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

9

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

entitled

to land free from trespassing animals?

Or is the rancher

entitled

to 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) But entitlement is negotiable (I can choose to sell/give up my right)

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) But entitlement is negotiable (I can choose to sell/give up my right) 

Liability

rule /

damages

  Violations of my entitlement are

compensated Damages

– payment to victim to compensate for damage done 

Inalienability

 Violations punished as a crime  Unlike property rule, the entitlement cannot be sold

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

Comparing injunctive relief to damages – example E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100  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

First, we consider the non-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 has right to

injunction

 E installs scrubbers, earns 1,000 – 500 = 500  L earns 300 E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100

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

What about with bargaining?

E payoff (non-coop) L payoff (non-coop) Combined payoff (non-coop) Gains from Coop E payoff (coop) L payoff (coop) Combined Polluter’s Rights 1,000 200 1,200 0 1,000 200 1,200 Damages 800 300 1,100 100 1,200 E profits = 1,000 L profits = 300  100 E prevention = 500 L prevention = 100 Injunction 500 300 800 400 1,200

Comparing injunctions to damages…  Injunctions are generally cheaper to administer  No need for court to calculate amount of harm done

Comparing injunctions to damages…  Injunctions are generally cheaper to administer  No need for court to calculate amount of harm done  Damages are generally more efficient when private bargaining is impossible     Three possibilities: injurer prevents harm, injuree prevents harm, nobody prevents harm (someone pays for it) Efficiency: cheapest of the three Damages: injurer can prevent harm or pay for it; injurer chooses whichever is cheapest Injunction: injurer can only prevent harm

So now we know…  Any rule leads to efficient outcomes when TC are low  Injunctions are cheaper to implement  Damages lead to more efficient outcomes when TC high  Leads Calabresi and Melamed to the following conclusion: When

transaction costs are low

, a

property rule

(injunctive relief) is more efficient When

transaction costs are high

, a

liability rule

(damages) is more efficient

Exactly agrees with our earlier principle  Transactions costs low: design law to facilitate trade  Property rule does this: clarifies right, allows trade  Transaction costs high: design law to minimize losses due to failures of private bargaining  Liability rule does this: gives injurer right to violate entitlement when efficient, even without prior consent

High transaction costs  Low transaction costs  damages 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.”

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 asymmetric information can be an impediment to trade

Third way to protect an entitlement: inalienability  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium)

Third way to protect an entitlement: inalienability  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium)  “Indirect” externalities (human organs)

Third way to protect an entitlement: inalienability  Inalienability: when an entitlement is not transferable or saleable  Allocative externalities (enriched uranium)  “Indirect” externalities (human organs)  Paternalism source: http://www.shanghaidaily.com/nsp/ National/2011/06/02/Boy%2Bregrets%2Bselling %2Bhis%2Bkidney%2Bto%2Bbuy%2BiPad/

Another interpretation of inalienability: bans on “repugnant markets”  “Repugnant markets”    markets that are illegal because people find them morally or aesthetically objectionable CA ban on serving horse and dog meat

Paying

birth mother to adopt a child   Bans on

dwarf tossing

Ticket scalping, price gouging, gambling, drugs, prostitution

2012 Nobel Prize winner Al Roth

 Roth: repugnance an important constraint on markets    What people find repugnant changes over time Charging interest used to be repugnant!

Dwarf tossing

Repugnance has to be considered in practical market design 29

Our conclusions (from Calabresi/Melamed)  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 textbook  TC

low

: design law to

facilitate trade

(normative Coase)  TC

high

: design law to

not rely on bargaining

(normative Hobbes)

Four questions we need to answer what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

31

Public versus Private Goods

Private Goods Public Goods



rivalrous

– one’s consumption precludes another 

excludable

– technologically possible to prevent consumption  example: apple 

non-rivalrous



non-excludable

    examples defense against nuclear attack infrastructure (roads, bridges) parks, clean air, large fireworks displays 32

Public versus Private Goods  When

private goods are owned publicly

, they tend to be

overutilized/overexploited

33

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

34

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

35

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

36

This accords with the principle from Monday  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 37

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

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?

39

What can an owner do with his 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  Does it really? What about bans on repugnant markets? And… 40

“Maximum liberty” vs. government’s right to regulate  Ruling two 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” 41

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?

42

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

43

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

44

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 Slow

Firm 2

Fast Slow 45, 45 20, 50 Fast 50, 20 25, 25 45

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  Slow Fast Slow 45, 45 45,

25

Fast

25

, 45 25, 25 46

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

.

47

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 48

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 49

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.

50

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.

” 51

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

52