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UW-Madison ECON 522 - ECON 522 Lecture Notes

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Econ 522 Lecture 4 Jan 29 2009 Tuesday we introduced some game theory talked a little bit about the big questions that property law has to answer and introduced Coase Since it s pretty important I want to spend a little more time on the 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 who owns what to start with will matter for distribution but will not matter for efficiency Return to Coase s example a rancher who raises cattle next door to a farmer There is a risk that the rancher s herd will wander onto the farmer s land and eat some of his crops And there are several ways to reduce this risk the farmer could build a fence around his crops the rancher could fence in his herd the rancher could reduce the size of his herd the farmer could reduce the size of his crops or plant something the cows don t like or plant something the cows don t like around the edges Coase makes two key points first don t pose the question as the rancher harming the farmer o the harm only happens because of both parties activities o so think of both of them as causing the harm but second as long as there are no transaction costs and the rancher and farmer are free to negotiate with each other whichever solution is the most efficient whether it s to do nothing and live with the harm or for the rancher to build fence or for the farmer to build a fence or one of the other ones or some combination is the one that will end up happening so who starts out with responsibility for any damage that occurs doesn t matter for efficiency we ll get the efficient result either way as long as property rights are clear and tradeable and there are no transaction costs 1 I mentioned Tuesday as I was running out of time that Coase lists a bunch of examples An early English case of a building which was built in such a way that it blocked air currents from turning a windmill A building in Florida which cast a shadow over the swimming pool and sunbathing areas of a nearby hotel A doctor whose office was next door to a confectioner who built a new examination room and found that the vibration from the confectionery s machinery prevented him from listening to his patients chests through a stethoscope in that room A chemical manufacturer whose fumes interacted with a weaver s products while they were drying after bleaching A house whose chimney no longer worked well after its neighbors rebuilt their house to be taller In each case he argues regardless of who is held to be liable the parties can negotiate with each other and take whatever remedy is cheapest to fix or endure the situation To quote Coase Judges have to decide on legal liability but this should not confuse economists about the nature of the economic problem involved In the case of the cattle and the crops it is true that there would be no crop damage without the cattle It is equally true that there would be no crop damage without the crops The doctor s work would not have been disturbed if the confectioner had not worked his machinery but the machinery would have disturbed no one if the doctor had not set up his consulting room in that particular place 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 desireable that both parties should take the harmful effect 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 2 The point he makes here about a smoothly operating pricing system is that opportunity costs matter Suppose I m the farmer and it would cost me 200 to build a fence to protect my crops and it would cost the rancher 400 Now suppose we re in a farmer s rights world where it s the rancher s responsibility to stop his herd from causing any damage I have no direct incentive to build a fence o It costs me 200 and I get no direct benefit But under a smoothly operating pricing system not building a fence also costs me money o If the rancher would be willing to pay me 400 to build the fence then not building the fence costs me 400 o So under a smoothly operating pricing system it would be more costly for me not to build the fence than to build it o And this would only be true if me building the fence is efficient o So we ll get to efficiency for sure regardless of where we started Let s go back to the car example to illustrate a few more things about bargaining I have a car it s worth 3 000 to me and it s worth 5 000 to you And suppose that you have 10 000 so being able to afford the car isn t an issue 3 000 is called my threat point It s the level of utility that I can guarantee myself by not trading with you So there s no reason for me to accept an outcome where I end up with less than 3000 worth of utility This is also called my reservation utility or my outside option since it s what I can get by refusing to cooperate 10 000 is your threat point You already have 10 000 so there s no reason for you to settle for an outcome worth any less than that Making negotiations voluntary we both have to agree to any trade means neither of us will ever accept a deal worse than our threat point 3 If we don t trade I end up with utility equivalent to 3 000 you have 10 000 so our combined surplus is 13 000 Suppose we do trade I sell you the car for some price P Now I end up with P you end up with 5 000 10 000 P and our combined surplus is 15 000 2 000 are the gains from trade This is the amount of new surplus we can create if we cooperate Now we both have to end up with at least as much utility as our threat point and our combined utilities will be 2 000 higher if we cooperate so our negotiations can be thought of as figuring out how to divide these gains that is in the final outcome we will each get our threat point plus some fraction of the gains from trade There are lots of different approaches to actually modeling bargaining some are based on certain axioms or assumptions some use game theory in …


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UW-Madison ECON 522 - ECON 522 Lecture Notes

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