Econ 522 Economics of LawOutlineSlide 2The Coase TheoremAn example of the Coase TheoremCoaseExample Coase uses: a rancher and a farmerSlide 8Example: rancher and farmerOther examples from CoaseQuoting from Coase (p. 13):Slide 12So, summing up…Slide 13Some vocabulary about bargainingSlide 16Slide 17Let’s go back to the rancher and farmerRelating Coase to general equilibrium/ first welfare theoremSlide 20Slide 20We motivated property law by looking at a game between two neighboring farmersHarold Demsetz (1967), “Toward a Theory of Property Rights”Slide 24Slide 25Friedman tells a similar story: “we owe civilization to the dogs”Slide 27Slide 28So…Slide 29Slide 31Quoting Coase…We can see the Coase Theorem as either a positive or negative resultSlide 33Up next:Econ 522Economics of LawDan QuintSpring 2010Lecture 42Last lecture, we…introduced static games, the matrix representation of payoffs, and how to find equilibriamotivated the need for property law (“anarchy is inefficient”)Today…the Coase TheoremOutline3Coase4Ronald Coase (1960), “The Problem of Social Cost”In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency.So the initial allocation of rights doesn’t matter for efficiencyHowever, it does matter for distributionAnd if there are transaction costs, it may matter for efficiency tooThe Coase Theorem5Your car – worth $3,000 to you, $4,000 to meIf I start out owning the car:no reason for you to buy it, I end up with it efficientIf you start out owning the car:clear incentive for me to buy it, I end up with it efficientI’d rather start with it, you’d rather start with it……but either way, we get to the efficient outcomeThe key: lack of transaction costsAn example of the Coase Theorem6“In the absence of transaction costs, if property rights are well-defined and tradeable, voluntary negotiations will lead to efficiency”You want to have a party next door to my apartmentThink of “party rights” like an objectI start off with “party rights” (right to be undisturbed):You can buy them if they’re worth more to you (and your guests)You start off with party rights (right to have party):I can buy them if quiet is worth more to me than party is to youWhoever starts with them, we still get to efficiencyCoase7Example Coase uses: a rancher and a farmer8Example Coase uses: a rancher and a farmer9Three possibilities:Rancher builds fence around herd… $400Farmer builds fence around crops… $200Do nothing, live with damage… $0If expected damage = $100…If expected damage = $500…Example: rancher and farmer10Lots of examples from case lawa building that blocked air currents from turning a windmilla building which cast a shadow over the swimming pool and sunbathing area of a hotel next doora doctor next door to a confectionera chemical manufacturera house whose chimney no longer worked well after the neighbors rebuilt their house to be tallerIn 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 situationOther examples from Coase11Judges 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…Quoting from Coase (p. 13):12If 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):13Coase 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 costsSo, summing up…14Bargaining15Example from before:Your car is worth $3,000 to you, and $4,000 to meSuppose 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 bargaining16If I don’t buy the car from you…my payoff is 10,000 (my threat point)your payoff is 3,000combined payoffs are 13,000If 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 trade (or gains from cooperation)no trade combined payoffs of $13,000I buy car combined payoffs of $14,000if we cooperate, our combined payoffs increase by $1,000Some vocabulary about bargaining17Threat points: 10,000 and 3,000Gains from cooperation: 1,000If gains from cooperation were divided equally…we’d each get 500 more than threat pointmy payoff would be 10,500, yours 3,500Which means P = $3,500(Coase doesn’t say gains will be divided equally, just that they’ll be divided in some way)Some vocabulary about bargaining18Cows 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 Cooperation0-200Farmer’s Threat Point-4000Rancher’s Threat PointFarmer’s RightsRancher’s Rights19General equilibriumgiven prices, consumers maximize utilitygiven prices, firms maximize profitsprices are such that all markets
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