The Coase Theorem: Efficiency and Property Rights, Slides of Economics and Law

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Econ 522

Economics of Law

Dan Quint

Fall 2016

Lecture 4

 Defined efficiency

 Maximizing total surplus achieved by everyone in society…

 …with value measured by willingness-to-pay

 Asked whether efficiency is a good normative goal for a

legal system

 Posner: yes, because ex ante (before we knew which part we would

play), we’d all agree to efficient rules

 Cooter and Ulen: yes, because even if society has other goals in

mind, such as redistribution, it’s better to make the law efficient and

achieve redistribution through taxes

So far, we have…

 We asked whether efficiency is a good normative goal for a

legal system

 What are other plausible normative goals for a legal

system?

 When would you expect them to agree with, or conflict

with, efficiency?

But first, an open discussion question

Property Law

 (^) Ronald Coase (1960), “The Problem of Social Cost”  (^) In the absence of transaction costs, if property rights are well-defined and tradable, voluntary negotiations will lead to efficiency.  (^) It doesn’t matter how rights are allocated initially…  (^) …because if they’re allocated inefficiently at first, they can always be sold/traded…  (^) so the allocation will end up efficient anyway  (^) Initial allocation does matter for distribution , though  (^) And if there are transaction costs , may matter for efficiency too The Coase Theorem Ronald Coase 1910-

 (^) Obviously, efficient for me to own it…  (^) …but we don’t need the law to give me the car  (^) If I start out owning the car: no reason for you to buy it, I end up with it  efficient  (^) If you start out owning the car: clear incentive for me to buy it, I end up with it  efficient  (^) Regardless of who owns the car at first, we get to the efficient outcome  (^) I’d rather start out with the car – so I don’t have to pay you for it  (^) You’d rather start out with it – so you end up with more money  (^) Efficiency doesn’t care about distribution – how much money we each end up with – just who ends up with the car at the end.  (^) And that doesn’t depend on who starts with it.  (^) The key: lack of transaction costs Example of Coase: you have a car worth $3,000 to you, $4,000 to me

 (^) Property rights have to be well-defined …  (^) It must be clear on who has what rights to start with, so we know the starting point for negotiations  (^) …and tradable …  (^) We need to be allowed to sell/transfer/reallocate rights if we want  (^) …and there can’t be transaction costs  (^) It can’t be difficult or costly for us to buy/sell the right  (^) So, the Coase Theorem: In the absence of transaction costs , if property rights are well-defined and tradable , voluntary negotiations will lead to efficiency. The conditions for this to hold

Coase’s example: a rancher and a farmer

Open range versus closed range

 (^) If it’s cheaper for the farmer to protect his crops than for the rancher to control his herd…  (^) Under open range law, that’s what he’ll do  (^) Under closed range law, rancher can pay farmer to build fence  (^) If smaller herd is more efficient, farmer can pay rancher to keep fewer cattle  (^) Coase:  (^) Whatever is the efficient combination of cattle, crops, fences, etc.…  (^) …the rancher and farmer will negotiate to that efficient outcome, regardless of which law is in place…  (^) …as long as the rights are well-defined and tradable and there are no transaction costs Coase: either law will lead to efficiency

 (^) Three possibilities:  (^) Rancher builds fence around herd… costs $  (^) Farmer builds fence around crops… costs $  (^) Do nothing, live with damage… costs nothing  (^) If expected crop damage = $  (^) Open range: farmer lives with damage rather than building fence  (^) Closed range: rancher pays for damage rather than fence  (^) If expected crop damage = $  (^) Open range: farmer builds fence – efficient  (^) Coase: closed range: rancher pays farmer to build fence  (^) So efficient outcome under either rule Rancher and farmer: numerical example

 (^) Lots of examples from case law  (^) a building that blocked air currents from turning a windmill  (^) a building which cast a shadow over the swimming pool and sunbathing area of a hotel next door  (^) a doctor next door to a confectioner  (^) a chemical manufacturer  (^) a house whose chimney no longer worked well after the neighbors rebuilt their house to be taller  (^) In each case, regardless of who is initially held liable, the parties can negotiate with each other and take whichever remedy is cheapest to fix (or endure) the situation Other examples from Coase

If we are to discuss the problem in terms of causation, both

parties cause the damage.

If we are to attain an optimum allocation of resources, it is

therefore desirable that both parties should take the

harmful effects into account when deciding on their course

of action.

It is one of the beauties of a smoothly operating pricing

system that… the fall in the value of production due to the

harmful effect would be a cost for both parties.

Quoting from Coase (p. 13):

 If the cheapest alternative is for the farmer to build a fence

for $200…

 The cost to build a fence is $

 But the cost to not build a fence is more than $200 – since under a

closed-range law, the farmer could ask the rancher for more than

$200 to build the fence

 “Opportunity cost”

What does Coase mean by “a cost for both parties”?