econ 522 economics of law dan quint spring 2013 lecture 7

Econ 522Economics of Law

Dan Quint

Spring 2013

Lecture 7

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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

Logistics

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Can UW undergrads reallocate poker chips efficiently?

(Cost me $173 to find out)

Lots to talk about!

Monday, we “tested the Coase Theorem”

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Take 1: Full Information (values on nametags)

Our experiment…

100%606032

purple chip2

purple chip4

purple chip4

6

purple chip6

purple chippurple chip8

purple chippurple chipred chip8



red chip12

fraction of potential gains realized

actual final allocation

efficientallocation

startingallocation

red chip

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Take 2: Private Information (values hidden)

Our experiment…

11/24 = 46%354824

purple chip2

purple chip3

purple chip3

4

purple chip

purple chip4

purple chip

purple chip6

purple chipred chip6


red chippurple chip8

purple chip

red chip10

fraction of potential gains realized

actual final allocation

efficientallocation

startingallocation

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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…)

Our experiment…

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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

Conclusion

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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

Considering the asymmetric-info case

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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!

Comparing pure uncertainty to asymmetric information

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Transitioning back toproperty law…

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(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?

Discussion question

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what can be privately owned?

what can an owner do?

how are property rights established?

what remedies are given?

How do we design an efficient property law system?

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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

Calabresi and Melamed: Low TC injunctions, high TC damages

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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.”

Low transaction costs injunctive relief

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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

So, do we buy it?

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“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)

A different view of the high-transaction-costs case…

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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

What can an owner do with his property?

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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”

“Maximum liberty” vs. government’s right to regulate

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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”?)

Fugitive property

Hammonds Central KY

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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

Two principles for establishing ownership

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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

First Possession versus Tied Ownership

45, 45 20, 50

50, 20 25, 25

Slow Fast

Slow

Fast

Firm 2

Firm

1

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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

First Possession versus Tied Ownership

45, 45 45, 25

25, 45 25, 25

Slow Fast

Slow

Fast

Firm 2

Firm

1

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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.

This brings us to the following tradeoff:

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“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

We’ve already seen two examples of this

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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

Another nice historical example: the Homestead Act of 1862

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“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

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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.”

Friedman on the Homestead Act of 1862

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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

So, what does an efficient property law system look like?

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SequentialRationality

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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 and sequential rationality

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Dynamic games

FIRM 1 (entrant)

Enter Don’t EnterFIRM 2(incumbent)

Accommodate Fight

(10, 10) (-10, -10)

(0, 30)

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”

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We can look for equilibria like before we find two: (Enter, Accommodate), and (Don’t Enter, Fight) question: are both equilibria plausible? sequential rationality

We can put payoffs from this game into a payoff matrix…

10, 10 -10, -10

0, 30 0, 30

Accommodate Fight

Enter

Don’t Enter

Firm 2’s ActionF

irm 1

’s A

ctio

n

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Dynamic games

FIRM 1 (entrant)

Enter Don’t EnterFIRM 2(incumbent)

Accommodate Fight

(10, 10) (-10, -10)

(0, 30)

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

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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

The key assumption behind subgame perfect equilibrium: common knowledge of rationality

econ 522 economics of law dan quint spring 2013 lecture 7

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