Econ 522 Economics of LawOutlineSlide 2From last week: the Coase TheoremExample: rancher and farmerSome vocabulary about bargainingSlide 7Let’s go back to the rancher and farmerRelating Coase to general equilibrium/ first welfare theoremSlide 9Slide 10We motivated property law by looking at a game between two neighboring farmersHarold Demsetz (1967), “Toward a Theory of Property Rights”Slide 14Slide 15So…Slide 16Slide 18Quoting Coase…We can see the Coase Theorem as either a positive or negative resultSlide 20What are transaction costs?Bargaining costs come in many formsSlide 24Slide 25Slide 26Slide 27Sources of transaction costsSlide 28What we know so far…Two normative approaches to property lawSlide 32Which approach should we use?Coming up…Econ 522Economics of LawDan QuintFall 2009Lecture 42Last lecture, we…introduced static games, the matrix representation of payoffs, and how to find equilibriamotivated the need for property law (“anarchy is inefficient”)introduced the Coase TheoremToday…more on Coasewhat are transaction costs, and what happens when they are present?Demsetz on when (and why) property rights developOutline3Coase4Coase 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 costsFrom last week: the Coase Theorem5Three possibilities:Rancher builds fence around herd… $400Farmer builds fence around crops… $200Do nothing, live with damageIf 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.”Example: rancher and farmer6Example from before:Your car is worth $3,000 to you, and $4,000 to me; I have $10,000$10,000 is my threat pointthe payoff I can get on my own, by refusing to cooperate with youalso called reservation utility, or outside option$3,000 is your threat pointAny outcome we both agree to must make us both at least as well-off as our threat pointSome vocabulary about bargaining7Suppose I buy the car for some price Pmy payoff is 4,000 + 10,000 – P = 14,000 – Pyour payoff is Pcombined payoffs are 14,000 – P + P = 14,000$1,000 are the gains from tradeno trade combined payoffs of $13,000I buy car combined payoffs of $14,000if we cooperate, our combined payoffs increase by $1,000If gains from trade were divided equally…we’d each get 500 more than threat pointmy payoff is 10,500, yours is 3,500, which means P = $3,500(Coase doesn’t say gains will be divided equally)Some vocabulary about bargaining8Cows do $500 damage; fence around herd costs $400; fence around crops costs $200Let’s go back to the rancher and farmer-200-200Combined Payoffs100-200Farmer’s Payoff-3000Rancher’s Payoff (IF…)2000Gains From Trade0-200Farmer’s Threat Point-4000Rancher’s Threat PointFarmer’s RightsRancher’s Rights9General equilibriumgiven prices, consumers maximize utilitygiven prices, firms maximize profitsprices are such that all markets clearFirst Welfare Theorem: general equilibrium is efficientBut not when there are externalities, or “missing markets”Allowing the consumer to negotiate with the firm is like introducing a “missing market” in air rightsRelating Coase to general equilibrium/first welfare theorem1011Demsetz1212We motivated property law by looking at a game between two neighboring farmers10 – c, 10 – c -5 – c, 12 – P12 – P, -5 – c -P, -PFarm StealFarmStealPlayer 2Player 110, 10 -5, 1212, -5 0, 0Farm StealFarmStealPlayer 2Player 1MODIFIED GAMEORIGINAL GAMEChanging the game had two effects:Allowed us to “cooperate” by not stealingIntroduced a cost c of administering a property rights system13“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.”Harold Demsetz (1967), “Toward a Theory of Property Rights”14“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”Private ownership of land among Native AmericansCost of administering private ownership: mediumBefore fur trade…externality was small, so gains from internalization were smallgains < costs no private ownership of landHarold Demsetz (1967), “Toward a Theory of Property Rights”15“Property rights develop to internalize externalities when the gains from internalization become larger than the cost of internalization.”Private ownership of land among Native AmericansCost of administering private ownership: mediumBefore fur trade…externality was small, so gains from internalization were smallgains < costs no private ownership of landAs fur trading developed…externality grew, so gains from internalization grewgains > costs private property rights developedHarold Demsetz (1967), “Toward a Theory of Property Rights”16Coase: if property rights are complete and tradeable, we’ll always get efficiencyDemsetz: yes, but this comes at a costProperty rights will expand when the benefits outweigh the costseither because the benefits rise……or because the costs fallOf course, Coase wasn’t completely ignoring costs…So…17Transaction Costs18Coase: “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 efficiencyCar example (yet again)If transactions are costly, we may not tradeAnd if we do trade, we incur that costSo…19“If market transactions were costless, all that matters (questions of equity apart)
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