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					      Econ 522
   Economics of Law


Dan Quint
Fall 2009
Lecture 4
 Outline


 Last lecture, we…
    introduced static games, the matrix representation of payoffs, and
     how to find equilibria
    motivated the need for property law (“anarchy is inefficient”)
      introduced the Coase Theorem


 Today…
    more on Coase
    what are transaction costs, and what happens when they are
     present?
    Demsetz on when (and why) property rights develop

                                                                          1
Coase




        2
 From last week: the Coase Theorem


 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…

      …although it does matter for distribution…

      …and it may matter for efficiency if there are transaction costs


                                                                             3
 Example: rancher and farmer

 Three possibilities:
      Rancher builds fence around herd… $400
      Farmer builds fence around crops… $200
      Do nothing, live with damage


 If expected damage = $100…

 If expected damage = $500…

 Coase: “One of the beauties of a smoothly operating
  pricing system… the fall in the value of production due
  to the harmful effect would be a cost for both parties.”
                                                             4
 Some vocabulary about bargaining

 Example from before:
      Your car is worth $3,000 to you, and $4,000 to me; I have $10,000


 $10,000 is my threat point
      the payoff I can get on my own, by refusing to cooperate with you
      also called reservation utility, or outside option


 $3,000 is your threat point

 Any outcome we both agree to must make us both at least
  as well-off as our threat point
                                                                           5
 Some vocabulary about bargaining

 Suppose I buy the car for some price P
      my payoff is 4,000 + 10,000 – P = 14,000 – P
      your payoff is P
      combined payoffs are 14,000 – P + P = 14,000

 $1,000 are the gains from trade
      no trade  combined payoffs of $13,000
      I buy car  combined payoffs of $14,000
      if we cooperate, our combined payoffs increase by $1,000

 If gains from trade were divided equally…
      we’d each get 500 more than threat point
      my payoff is 10,500, yours is 3,500, which means P = $3,500
      (Coase doesn’t say gains will be divided equally)
                                                                     6
 Let’s go back to the rancher and farmer

 Cows do $500 damage; fence around herd costs $400;
  fence around crops costs $200

                          Rancher’s Rights   Farmer’s Rights

 Rancher’s Threat Point           0               -400

 Farmer’s Threat Point         -200                  0

 Gains From Trade                 0                200

 Rancher’s Payoff (IF…)           0               -300

 Farmer’s Payoff               -200                100

 Combined Payoffs              -200               -200
                                                               7
 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
                                                               8
9
Demsetz




          10
 We motivated property law by looking at a
 game between two neighboring farmers

                    ORIGINAL GAME                                     MODIFIED GAME

                             Player 2                                        Player 2
                    Farm                Steal                         Farm              Steal

            Farm    10, 10              -5, 12              Farm 10 – c, 10 – c -5 – c, 12 – P
 Player 1




                                                 Player 1
            Steal   12, -5              0, 0                Steal 12 – P, -5 – c        -P, -P



 Changing the game had two effects:
        Allowed us to “cooperate” by not stealing
        Introduced a cost c of administering a property rights system                           11
 Harold Demsetz (1967), “Toward a Theory
 of Property Rights”
 “A primary function of property rights is that of guiding
  incentives to achieve a greater internalization of
  externalities”

 “[ In order for an externality to persist, ] The cost of a
  transaction in the rights between the parties… must exceed
  the gains from internalization.”

 “Property rights develop to internalize externalities when
  the gains from internalization become larger than the
  cost of internalization.”

                                                               12
 Harold Demsetz (1967), “Toward a Theory
 of Property Rights”
 “Property rights develop to internalize externalities when
  the gains from internalization become larger than the
  cost of internalization.”

 Private ownership of land among Native Americans
      Cost of administering private ownership: medium
      Before fur trade…
           externality was small, so gains from internalization were small
           gains < costs  no private ownership of land




                                                                              13
 Harold Demsetz (1967), “Toward a Theory
 of Property Rights”
 “Property rights develop to internalize externalities when
  the gains from internalization become larger than the
  cost of internalization.”

 Private ownership of land among Native Americans
      Cost of administering private ownership: medium
      Before fur trade…
           externality was small, so gains from internalization were small
           gains < costs  no private ownership of land
      As fur trading developed…
           externality grew, so gains from internalization grew
           gains > costs  private property rights developed

                                                                              14
 So…

 Coase: if property rights are complete and tradeable, we’ll
  always get efficiency

 Demsetz: yes, but this comes at a cost

 Property rights will expand when the benefits outweigh the
  costs
      either because the benefits rise…
      …or because the costs fall


 Of course, Coase wasn’t completely ignoring costs…
                                                            15
Transaction Costs




                    16
 So…

 Coase: “in the absence of transaction costs,
  if property rights are well-defined and tradeable,
  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



                                                       17
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 as we have seen, 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.

                                                                   18
 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 tradeable, 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                                                19
What Are Transaction
      Costs?




                       20
 What are transaction costs?

 Anything that makes it difficult or expensive for two parties
  to achieve a mutually beneficial trade

 Three categories
      Search costs – difficulty in finding a trading partner
      Bargaining costs – difficulty in reaching an agreement
      Enforcement costs – difficulty in enforcing the agreement
       afterwards




                                                                   21
 Bargaining costs come in many forms


 Asymmetric information
      Akerloff (1970), “The Market for Lemons” – adverse selection




                                                                      22
 Bargaining costs come in many forms


 Asymmetric information
      Akerloff (1970), “The Market for Lemons” – adverse selection


 Private information (don’t know each others’ threat points)
      Myerson and Satterthwaite (1983), “Efficient Mechanisms for
       Bilateral Trading” – always some chance of inefficiency




                                                                      23
 Bargaining costs come in many forms


 Asymmetric information
      Akerloff (1970), “The Market for Lemons” – adverse selection


 Private information (don’t know each others’ threat points)
      Myerson and Satterthwaite (1983), “Efficient Mechanisms for
       Bilateral Trading” – always some chance of inefficiency


 Uncertainty
      If property rights are ambiguous, threat points are uncertain, and
       bargaining is difficult


                                                                            24
 Bargaining costs come in many forms


 Large numbers of parties
      Developer values large area of land at $1,000,000
      10 homeowners, each value their plot at $80,000




                                                           25
 Bargaining costs come in many forms


 Large numbers of parties
      Developer values large area of land at $1,000,000
      10 homeowners, each value their plot at $80,000
      Holdout, freeriding


 Hostility




                                                           26
 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

                                                                    27
So, what do we do?




                     28
 What we know so far…


 No transaction costs  initial allocation of rights doesn’t
  matter for efficiency
      wherever they start, people will trade until efficiency is achieved


 Significant transaction costs  initial allocation does matter,
  since trade may not occur (and is costly if it does)

 This leads to two normative approaches we could take



                                                                             29
 Two normative approaches to property law


 Design the law to minimize transaction costs
      “Structure the law so as to remove the impediments to private
       agreements”
      Normative Coase
      “Lubricate” bargaining




                                                                       30
 Two normative approaches to property law


 Design the law to minimize transaction costs
      “Structure the law so as to remove the impediments to private
       agreements”
      Normative Coase
      “Lubricate” bargaining


 Try to allocate rights efficiently to start with, so bargaining
  doesn’t matter that much
      “Structure the law so as to minimize the harm caused by failures
       in private agreements”
      Normative Hobbes

                                                                          31
 Which approach should we use?

 Compare cost of each approach
      Normative Coase: cost of transacting, and remaining inefficiencies
      Normative Hobbes: cost of figuring out how to allocate rights
       efficiently (information costs)


 When transaction costs are low and information costs
  are high, structure the law so as to minimize transaction
  costs

 When transaction costs are high and information
  costs are low, structure the law to allocate property
  rights to whoever values them the most
                                                                       32
 Coming up…


 Tuesday: how should property rights be enforced?
      Calabresi and Melamed, Property Rights, Liability Rules, and
       Inalienability: One View of the Cathedral


 No lecture on Thursday October 1

 First HW will be posted soon, due Tuesday October 6

 First midterm Tuesday October 13, on property law


                                                                      33

				
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