Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Fall 2012 Lecture 6
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Our story so far on property law

• Coase absent transaction costs, if property
  rights are complete and tradable, well get
  efficiency through voluntary negotiation
• So we can always get efficient outcomes
  automatically
• provided there are no transaction costs
• But what to do when there are?

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Different types/sources of transaction costs

• Search costs
• Bargaining costs
• Asymmetric information/adverse selection
• Private information/not knowing each others
  threat points
• Uncertainty about property rights/threat points
• Large numbers of buyers/sellers holdout,
  freeriding
• Hostility
• Enforcement costs

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Two normative approaches to the law

• Normative Coase aim to minimize transaction
  costs
• Normative Hobbes aim to allocate rights
  efficiently (or minimize the need for
  bargaining/trade)
• How to choose between the two?
• When transaction costs are low and information
  costs high, design law to minimize transaction
  costs
• What transaction costs are high and information
  costs are low, design law to allocate rights
  efficiently

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Two normative approaches to the law

• Defaulting to the normative Coase approach means
  relying on bargaining to reallocate rights
  efficiently
• Is it realistic to think this will work in real
  life?
• Is it realistic to think this would work in a
  room full of undergrad econ majors?

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An experiment onCoasian bargaining
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Experiment Coasian bargaining

• Round 1 (full information)
• Ten people, five of them have a poker chip to
  start
• Each person is given a personal value for a poker
  chip
• At the end of the round, thats how much you can
  trade in a chip for
• Purple chip is worth that number, red chip is
  worth 2 x your number
• So if your number is 6 and you end up with a
  purple chip, Ill give you 6 for it if you end
  up with a red chip, Ill give you 12 for it
• Each person can only sell back one chip
• Your number is on your nametag (common knowledge)

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Experiment Coasian bargaining

• Round 2 (private information)
• Ten people, five of them have a poker chip to
  start
• Each person is given a personal value for a poker
  chip
• At the end of the round, thats how much you can
  trade in a chip for
• Purple chip is worth that number, red chip is
  worth 2 x your number
• So if your number is 6 and you end up with a
  purple chip, Ill give you 6 for it if you end
  up with a red chip, Ill give you 12 for it
• Each person can only sell back one chip
• Only you know your number

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Experiment Coasian bargaining

• Round 3 (uncertainty)
• Six people, three poker chips
• Value of each chip is determined by a die roll
• If seller keeps the chip, its worth 2 x roll of
  the die
• If new buyer buys chip, its worth 3 x roll of
  the die
• No contingent trades buyer must pay cash
• Nobody sees the die roll until the end

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Experiment Coasian bargaining

• Round 4 (asymmetric information)
• Six people, three poker chips
• Value of each chip is determined by a die roll
• If seller keeps the chip, its worth 2 x roll of
  the die
• If new buyer buys chip, its worth 3 x roll of
  the die
• No contingent trades buyer must pay cash
• Seller sees the die roll initially, buyer does not

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Back to work
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Last week what things should be privately owned?

• Public Goods
• non-rivalrous, non-excludable
• tend to be underprovided when privately supplied
• tend to have high transaction costs (many people
  involved)
• suggests public provision/regulation preferable
• Private goods
• rivalrous, excludable
• tend to be overexploited when publicly owned
• tend to have low transaction costs (one buyer,
  one seller)
• suggests private ownership preferable

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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

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Another question choosing a remedy for property
rights violations

• Injunctive relief court clarifies right, bars
  future violation violations are punished as
  crimes (but right is tradable)
• Damages court determines how much harm was done
  by violation, awards payment to injuree
• Coase should be equally efficient if there are
  no transaction costs
• But in real world, which is more efficient?

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Comparing injunctive relief todamages example
E profits 1,000L profits 300 ? 100E
prevention 500L 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 Ls profits from 300 to 100
• E could stop polluting at cost 500
• L could prevent the damage at cost 100

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First, we consider thenon-cooperative outcomes
E profits 1,000L profits 300 ? 100E
prevention 500L prevention 100

• Polluters 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

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Noncooperative payoffs
E profits 1,000L profits 300 ? 100E
prevention 500L prevention 100
Injunction
Damages
Polluters Rights
500
800
1,000
E payoff(non-coop)
300
300
200
L payoff(non-coop)
800
1,100
1,200
Combined payoff (non-coop)
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What about with bargaining?
E profits 1,000L profits 300 ? 100E
prevention 500L prevention 100
Injunction
Damages
Polluters Rights
500
800
1,000
E payoff(non-coop)
300
300
200
L payoff(non-coop)
800
1,100
1,200
Combined payoff (non-coop)
400
100
0
Gains from Coop
700
850
1,000
E payoff (coop)
800 ½ (100)
500 ½ (400)
500
350
200
L payoff (coop)
300 ½ (100)
300 ½ (400)
1,200
1,200
1,200
Combined
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Comparing injunctions to damages

• Injunctions are generally cheaper to administer
• No need for court to calculate amount of harm
  done

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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

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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

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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

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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)
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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)

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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.

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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

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Third way to protect an entitlement
inalienability

• Inalienability when an entitlement is not
  transferable or saleable
• Allocative externalities(enriched uranium)

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Third way to protect an entitlement
inalienability

• Inalienability when an entitlement is not
  transferable or saleable
• Allocative externalities(enriched uranium)
• Indirect externalities(human organs)

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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/Boy2Bregrets2Bselling2Bhis2Bkidney
2Bto2Bbuy2BiPad/
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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?
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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 doesnt impose an externality (nuisance) on
  anyone else

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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?
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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
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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

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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
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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
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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.

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A 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

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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.
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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.
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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

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Sequential Rationality(probably wont get to
this)
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Dynamic games and sequential rationality

• Game theory weve seen so far static games
• everything happens at once
• (nobody observes another players move before
  deciding how to act)
• Dynamic games
• one player moves first
• second player learns what first player did, and
  then moves

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Dynamic games
FIRM 1 (entrant)
Enter
Dont Enter
FIRM 2 (incumbent)
(0, 30)
Accommodate
Fight
(10, 10)
(-10, -10)

• A strategy is one players plan for what to do at
  each decision point he/she acts at
• In this case player 1s possible strategies are
  enter and dont, player 2s are accommodate
  and fight

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We can put payoffs from this game into a payoff
matrix
Firm 2s Action
Accommodate
Fight
10, 10
-10, -10
Enter
Firm 1s Action
0, 30
0, 30
Dont Enter

• We can look for equilibria like before
• we find two (Enter, Accommodate), and (Dont
  Enter, Fight)
• question are both equilibria plausible?
• sequential rationality

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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)
Enter
Dont Enter
FIRM 2 (incumbent)
(0, 30)
Accommodate
Fight
(10, 10)
(-10, -10)
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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