Chapter 4
PROPERTY
 

Private property is a bundle of rights that gives owners discretion over the use of resources.   Property is a collection of rights and entitlements that people have in relation to things and to other people.    Private property creates incentives for efficiency and innovation.  It does so because the costs and benefits of using of the resource property is internalized by the owner of the property.
What do we mean when we say costs and benefits of property are internalized by the owner of property?
 

These cost include implicit and explicitly cost.  As such it is in the owners self best interest to maximize the difference between benefits and cost.  As such, owners will sell or buy property if they feel it is increasing benefits more than costs.  Owners of property will try to organize their property to be efficient.

The law tries to provide legal protection of property so that incentives are made for the owners to use the resource efficiently.  When law creates exclusive rights to use property and those rights are transferable between owners of property then the law assures the efficient use of resources.
Can you imagine what it is like in Russia today where it is not clear who owns the property that the state formally owned?  Suppose, as an American, you want to buy a building from a Russian.  You pay him money (which could have been used for some other investment in Russia) for the building anticipating opening up a Pizza Hut restaurant.  We make the deal signing the necessary papers but when you are ready to renovate the building the police come and say you do not own the property.  They claim that the person who took my money did not have exclusive rights to the property and as such should not have sold it to you.  They tell you for $5,000 more (paid to them) you can have the building.  After you pay them another official does the same thing.  Since Russia did not have laws giving you exclusive use of property, inefficient allocations of resources occur.  (All the money being used to pay off these people could have been put into resources to be used in other more productive investments)

For example, if you are a farmer growing corn on your land it might be more productive to put that land in someone else's care.  You might build a shopping center or housing development on it.  If the farmer tries to maximize value he can be induced to transfer the property to someone who can put it to more productive use.  Allowing property to be transferred from one person to another so that all parties can maximize its value is the purpose of property law.

The economic theory of property rights implies that rights will be redefined from time to time as the relative values of different resource uses change.

We will show that if property law is written so as to encourage voluntary exchange by removing obstacles to bargaining then resources will be used efficiently.  Essentially, we will show that if exchange of property occurs and goes to the highest value, people will exchange property. As long as there are no obstacles to negotiating the exchange economic efficiency will occur.  The law must make this transition as easy as possible while protecting everyone’s rights.  As such when dealing with property laws the four following questions must be asked.

1.  What can be privately owned?
2.  How are ownership rights established?
3.  What may owners do with their property?
4.  How are property rights protected?  What are the remedies for their infringements?

We will now answer these questions.

1. What can be privately owned?

Does property have to be tangible like land or can it be intangible like a satellite orbit, trademarks, and a software program?  Suppose you develop a new software program that uses certain commands.  Does that mean you have complete ownership of that software?  The second example on page 75 asks what types of things can be privately owned.  Are things privately owned or owned by the public.  Who owns the satellite orbit?

Suppose you live next to the smoke stacks of NiMo, and every evening they load up the turbines with oil and a smell comes from the stacks that is offensive.  All of the landlords try to get the power plant closed.  Notice there is a tradeoff between competing activities.  The competing use is very confusing because we don't really know if the landlords are interfering with NiMo by trying to shut it down or is NiMo interfering with the homeowners?

Essentially parties in a dispute are trying to place limits on uses of land that cause harm or inconvenience to others.  There are two ways the law allows restrictions on what a person can do with property.  One is called private or " An action for nuisance" which is when a private individual seek to limit another party's uses of land that interfere with their use and enjoyment of their own land.  The second is public which is when the government enacts legislation imposing general restriction on the use of land, such as zoning, environmental regulation, landmark preservation, and rent control.  The books 4th example (on page 75) of a town passing a law that would forbid Bloggs from draining the wetlands on his property is an example of this public restriction of land.  That example deals with the 3rd question: what may owners legitimately do with their property?  How far can the government go by placing restrictions on an individual’s exercise of property rights?

The fifth example on page 76 deals with the concept of trespass, and what remedy should be enacted.  For example, suppose someone lives in a house whose roofline falls on your property.  The property has an alley that could be used for parking but since the house next to you has a roofline that prevents you from parking a large truck in the alley, you do not have access to your property. Can you make them cut part of the roof off? Or suppose 10 years ago you built a fence on the wrong side of you property line.  Your neighbor just discovered this and wants you to move the fence back 8 inches.

These are all interesting questions dealing with property and what can and can not be done with it.  Economic analysis provides a very good tool for fashioning remedies to these questions because through economic analysis outcomes of alternative legal remedies to property disputes can be predicted.

Legal concept of property

Property is based on the legal concept that property it is a bundle of rights over resources.  The owner of these resources is free to exercise those rights and has protection of preventing others trying to interfere with the exercise of those rights.  This is the same concept of the model of Perfect Competition where we assume freedom of mobility of resources.   Remember, in perfect competition we assumed that resources are free to move.  Property is a resource, it also must be free to move from one owner to another.  The law must be set up in such a way that owners of property are protected from private individuals or the government interfering with moving your resources freely.  Thus, if you want to sell your property you can do so and there are laws allowing a free flow of your property.
   The economic analysis of property allows us to analysis when and how others, including the government, can interfere with an owner’s property rights and the remedies available to the owner if there is some illegal or legal interference with those rights.

Bargaining Theory

At first you are probably thinking that economic models of markets will be used to deal with the above issues.  At this point most of us understand how prices can be established for different rules of law, and how these prices help allocate resources efficiently.  The beauty of the price system is that there are explicit prices and implicit prices that we must consider.

As useful as the analysis of markets are in studying law, the nature of bargaining in settling legal disputes is even more appropriate to developing an economic theory of property.  In particular, game theory is best suited for developing the economic theory of property.  Keep in mind when a person tries to buy property (or any resource) from an individual they must bargain over the terms of the transaction.  Often the bargaining involves bluffs and all types of “what if” strategies.  Suppose you are at a garage sale and see an item for $200 that you know you can sell it immediately for $275.  You stand to make $75 profit.  However, if you pay less your profit goes up.  There are many strategies in bargaining for this item.  You can ask politely if they can do any better.  If they say $100 you know they do not know what they have and they are willing to haggle.  You can offer them $60 and see what happens.  This is one strategy.   Another strategy is to immediately offer them $60.  If they know what they have they will tell you to jump in a lake and say $200 take it or leave it.  This bargaining strategy can backfire.  There are many bargaining strategies and game theory helps us analyze the different strategies.

Let’s set up a simple bargaining model.

Suppose Abby has a Mickey Mantel Rookie baseball card, which she values, to her, at $3000.  Barnie, who always wanted that card just won the lottery for $5000 and wants to buy the card from Abby.  Barney decides that based on the condition of the card it is worth $4000 to him.

Notice, the seller values the card less than the potential buyer does, so there is room for bargaining.  The sale price would have to be between the $3000 which Abby values the card at and $4000, which Barney values the card at.  One would think, if they bargain and split the difference they would set the price at $3500.

This seems pretty simple and common sense would dictate the solution.  Let’s make this bargaining game a bit more formal by stating everything in the language of game theory.

This is a cooperative game because both parties benefit from cooperation. The resource can be moved from someone who values it at $3000 to someone who values it at $4000.  Thus moving the resources from one person to another creates $1000 of value.  This value occurs because the resource is being moved to a more valuable use and the two parties are sharing the extra $1000.  The share of the $1000 they receive depends on the price the card is sold for.

The price is established by negotiations, both parties use their negotiating skills to derive the price so that the transaction occurs.  There is nothing saying they have to agree to a price, if they can’t agree there is a failure in the bargaining process.
 If the two parties agree to a price then its called a cooperative solution, if the can not agree then its called a non-cooperative solution.

If there is non-cooperation, a threat value is established.  In this case it is $3000 for Abby and $5000 for Barney.  The total value of non-cooperation is $8,000.  Before anyone strikes a bargain both sides must meet at the minimum threat value.

Suppose they sell the card for $3500 Let’s see what happens when both parties cooperated to make this deal.  Barney gets the card, which is worth $4000 to him plus he keeps $1500 cash.  Thus Barney has $5500 of value.  Abby gets $3500 so the $5500 plus $3500 equal $9000 of value.  Thus the value of cooperation is $9000 A surplus of cooperation is the difference between non cooperation and cooperation or $1000 of surplus.

The solution shows that each side receives at least their threat value plus an equal share of the cooperative surplus.  If the price is $3500 then Abby gets $3500 and Barney gets the card valued at $4000 + $1500 cash for at total of $9000.

The bargaining process has three steps:

1.  set the threat values
2.  determine the cooperative surplus
3.  set terms for splitting the surplus.
 

Cooperation in bargaining requires that both parties are able to get together to bargain and eventually establish ownership of property.  Cooperation is very efficient in allocating resources.  What happens if both parties can not get together to bargain?  Then it becomes almost impossible to get a cooperative surplus.  This is shown by the famous Prisoner’s Dilemma.
 

This type of analysis can be used to show that cooperation creates a surplus that benefits everyone.  More importantly we can show the role that economic behavior plays in the development of property law.

Assume that a radioactive meteor strikes the earth and destroys almost everyone and everything except for small areas of land with people on it.  The people still have agricultural and military technology since they remembered how to farm and fight.  There are no courts and no governments.

Imagine that families and individuals form clans to defend the property that they grow food on.  These people attach value to this non-contaminated land because they can grow food on it and it is not contaminated.  They form an army to exclude others from taking the property.  Many resources are used to keep the military strong so they can prevent others from taking the land.  We assume it is worthwhile to exclude people from the land.

Since individuals are rational they allocate their resources between farming and military so that the marginal cost of defending land is just equal to its marginal benefit.  Remember, if people defend the land, then they are not available to farm and grow food, thus opportunity cost is the marginal cost.  The value of the resources used for defense (benefit) is just equal to the value (opportunity cost) of the resources used for farming.  If people are rational putting extra resources into protecting the land will protect as much wealth as putting those resources into farming.

While all of this is rational behavior for individuals, is it efficient for society?
 
 

What do we mean by society being efficient?
 
 

In the above example, if society could be reorganized where the same inputs can produce a greater output then society would be inefficient.  Law can be one way to reorganize resources to get more output.

Remember people are putting resources into the military to prevent food from being stolen.  If society creates a method of protecting the property that is less expensive than the military, then those military resources can be used for growing more food.

One way of doing this is to establish a legal system that enforces property rights.  Remember that all survivors of the meteor are creating expensive armies to protect their property.  If a system is set up where there is a method of having property rights that are less costly than all of the individual armies then society can increase efficiently.  It is possible that each group would send some individuals over to join one big army to protect everyone's property.  This occurs because of economies of scale.  It would be cheaper to have one large army than many small expensive armies.

People will start negotiating over what type of government and army will protect their property. They negotiate each individuals share of the cost. As a result of having only one army people who were used in the individual armies are now free to farm.  They no longer have to worry about being attacked.   They now get more security and more food with the same level of resources.  Thus everyone’s enjoys more wealth and security.
 The final bargain that each group comes up with is what political scientist call the "social contract".  The same bargaining model can deal with showing how the concept of property develops legally with its economic underpinnings.

When there is no cooperation the non-cooperative solution is called the “state of nature”, which would have threat values of a non-cooperative game. As bargaining begins the benefits of creating a government to protect property rights would be discussed.  These benefits would be the same as a cooperative solution.

The social surplus is the equivalent of the cooperative surplus and is defined as the difference between the amount spent defending land without government and the total cost of operating a property rights system (government).

What is of interest here is how the bargaining framework can be applied to trying to establish a civil society.

When everyone cooperates, society was better off.  This was also shown in the baseball card example. If there is a breakdown in bargaining, because of disagreements, it becomes expensive for both parties since an agreement was not reached.  Consequently, we want a legal system with legal rules, which minimizes losses from disagreements.

This example shows why property rights are established.  Society creates property rights to encourage production, discourage theft, and reduce the costs of protecting goods.  The law shows different ways people acquire property rights.  Bargaining theory helps the legal system develop ways for the acquisition of property that encourages production, or discourages theft while reducing the costs of protecting goods.

Remember the four questions about property
1.  What can be privately owned?
2.  How are ownership rights established?
3.  What may owners do with their property?
4.  How are property rights protected?  What are the remedies for their infringements?

Sometimes we do not need property law to answer these.  If people can bargain without interference these questions will be answered privately and no law needs to made to allocate property.
 Sometimes the law imposes the terms of bargaining.  For example, the law establishes prior to bargaining what can and can’t be done.  Given this constraint established by the law the parties bargain over property.
 Usually the terms of striking a bargain are more efficient when people agree to them rather than when the lawmakers impose the bargain on them.

An economic theory of property
Law can put a limit on the movement of property.  The limit can be specified by what is called Coases theorem.

Coases Theorem as applied to the analysis of property law concludes the following. No matter what the rule of laws says about property if both sides to a property dispute are allowed to bargain, without any transaction costs, they will always reach an agreement that is efficient no matter what the law says.
 

What is the Coase Theorem?

"When parties can bargain together and settle their disagreements by cooperation, their behavior will be efficient regardless of the underlying rule of law.  Even if a law is inefficient, Coase maintains that private agreements, assuming that bargaining is successful, will remedy the inefficient allocation of resources made by the law and make resource allocation efficient.  The key here is that bargaining must be successful.  If there are no transaction costs to bargaining then it will be successful.
Thus we see that successful bargaining can cure inefficient law.

What is an example of an inefficient law?

Suppose both parties can not agree to a settlement and the law imposes a fine of $10,000 for not settling.   If the maximum combined profits of the two parties to the dispute is $9,000 and because they could not agree they must pay a fine of $10,000. The law is inefficient because it is costing them more than the profits they can potentially make.   On the other hand, if both sides bargain together they stand to make a profit of $9,000 which is efficient compared to the law which would cost them $10,000 for not agreeing.

You may ask why is it necessary to have law if successful bargaining can cure inefficient laws?

Suppose both sides cannot agree to do something because they are both very stubborn and hate each other.  Their attorneys tell them if they do not remedy the problem, the legal solution would have a remedy that they would have to follow.  (The legal solution can be an order to do something, an injunction, or a fine.)  The lawyers pointed out to both sides what these legal remedies are going to cost them if they do not agree.  Knowing these costs will alters the way the firms bargain because the law establishes costs if they do not agree.  Thus Laws effect how the resource is distributed between the two sides because now they must take into consideration what will happen (by legal remedy) if they do not agree.

For example: imagine bargaining over disputed property with your neighbor.  A law might provide a certain solution which may cost both of you a total of $10,000.  If you do not agree to a solution the cost will be $10,000.  However, if your neighbor says they will give you $5000 and forget about the problem and you agree, then it only cost $5000 to solve the problem and the resource went to the most valued person.  If you can bargain to an agreement then the law is almost immaterial.
 If there are no transaction costs to bargaining, Coase tells us that we will always reach an efficient bargain outcome no matter what the legal remedy is, provided that bargaining is successful.  However, if there are transaction costs then each side must take those costs into consideration and the legal remedy might be less expensive even though it is inefficient.  For example if transaction costs are big there may be no cooperative surplus to split, and the parties will just abide by the legal remedy.
As long as there are clear definition of who has the right to do what, then the market will take of the problem.
Transaction costs can be very big when more parties are involved in the dispute.  If there are only two parties it can be easy to negotiate.  But suppose there are 100 firms causing pollution and 90 say they are willing to pay to settle the dispute but the other 10 try to get a free ride.  Then the transaction costs of trying to get everyone to agree can be more expensive than solving the pollution problem.

Here is an example of Coase’s theorem.  Before we start remember we said that when there is a legal rule that rule will benefit one side in the dispute, but will harm the other side.  Keep this in mind as we run through an example of Coases theorem.

Suppose A pollutes, which causes harm to their neighbor B.  The legal rule can prevent A from polluting, which prevents B being harmed. But now A is harmed because A can no longer produce the good or A will have to incur the cost of pollution abatement.  The legal rule that stops harming  B now harms A.  This shows that when one side benefits from a legal rule another side is harmed.  The real question is should A be allowed to harm B or should B be allowed to harm A?  In order to maximize society’s wealth, the legal rule should be structured to avoid the more serious harm.
 Suppose the pollution generated by A causes $1 million in damage to downstream landowners (B).  A can prevent the pollution by installing filters that cost $600,000, whereas B could eliminate the damage at a cost of $300,000.
What does the efficiency concept tell us about damage?  i.e. should the pollution be stopped?  Why?
 
 
 
 

According to Coases theorem, no matter how the legal right to stop the pollution is assigned, the solution is for B to pay to stop the pollution.
 Suppose the court rules that downstream owner B has the right to be free from pollution.  (This is assigning the rights to B).  A can stop the pollution for $600,000.  But A also knows that B can stop the pollution for $300,000.  Thus B would be willing to take any payment above $300,000 to stop the pollution.  If there are no transaction cost, then a bargain will be struck that will have B remove the pollution.  A will pay up to $600,000 to stop the pollution.  There is a cooperative surplus of $300,000 that both sides can now negotiate over to see how it is distributed between them.
 Suppose instead the court assigns A the right to pollute.  The downstream landowners B is faced with a choice between incurring $1 million in property damage or spending $300,000 to prevent the damage.  B will choose to undertake the cheaper damage prevention.  Thus, no matter how the court assign the right to pollute or not to pollute, an efficient outcome will occur.  B will spend $300,000 to stop the pollution.
As long as there are no transaction costs, both sides will cooperate and bargain successfully regardless of how the law assigns the rights. Reaching an agreement through bargaining benefits everyone (welfare economics). It therefore makes sense that laws pertaining to property or contracts should remove obstacles to private bargaining.
This is one version of Coases theorem:
When transaction cost are zero, an efficient use of resources results from private bargaining, regardless of the legal assignment of property rights.
In a world of zero transaction cost private bargaining will take care of answering the questions dealing with property, i.e. who owns the property and what can they do with it?  According to Coase, property law is not really important when transaction costs are zero.  The opposite of this logic is what is really important about Coases theorem.

Since we know when property law is not important, the question becomes  when is property laws important?
 
 
 
 

The economic theory of property must identify the obstacles of bargaining and then show how legal rules overcome these obstacles.

These obstacles are what economist call transaction cost.   Transaction costs are simply the cost associated with exchange between two parties to a transaction.  For they’re to be an exchange of goods someone must want the good.  It can be expensive to find this person because you have to advertise and spend a lot of money trying to locate them.    Secondly you must strike a bargain between both parties. This will require both sides to negotiate.  Negotiating costs are expensive because you have to pay people to do it for you, or if you do it yourself you have opportunity cost.  Thirdly once the bargain is reached it must be enforced.  This means you need someone to monitor each other to make sure both sides are living up to the agreed upon bargain.  Violators must then be punished.

These are three types of transaction costs.
1.  Search (communication) costs.
2.  Bargaining cost.
3.  Enforcement cost.
 

Why are search costs higher for a unique good?
 
 
 

The Internet has lowered some of these search cost.  Firms no longer have to spend as much money advertising their goods.
 In order to reach a bargain both sides need to know the threat points of each side as well as the cooperative solution.  If one side does not know the threat point of the other side, it becomes costly to find out what it might be.  It also becomes difficult to bargain if it is expensive to find the cooperative solution. When threat values are known they are said to be public.  When they are not known it is said to be private.

 It might be in someone’s best interest not to show the cooperative solution.  With public information available about the threat and cooperative solutions, it is easier to cooperate and reach a, low transaction cost, agreement. Examples of this are consumers buying consumer goods.  This is an easy transaction because there is not that much to know about the goods. (Price is marked on the good)
 Private information makes bargaining more difficult because it is expensive to convert private into public information.  For example, buying a house has lots of public information but there is also private information.  Is the roof good or bad, are their termites?  The buyer has to hire an inspector to check all these things out.  The more private information the less likely will bargaining be successful.
Property law should favor determining ownership that is clear and simple.  That is why in America when purchasing a house the records of ownership are in the county building where anyone can get it.

An example of not knowing threat values and cooperative solutions can be shown in a tort cases involving personnel injury.  Suppose both plaintiff’s and defendants are far apart on reaching a settlement.  The plaintiff knowing that the insurance company is essentially the defendant runs the cost of litigation up for the insurance company when they do not settling.  (Defense attorneys are paid hourly by the insurance company.) Sometimes legal costs become so big the insurance company, in order to avoid the cost, will lower their threat point and pay a greater settlement amount.  For example, the defense might require the plaintiff attorney to go far away for a video medical testimony to be used at a trial. This means the plaintiff attorney has to spend one or two days away from their practice and can’t earn money.  When the plaintiff sees the defense means business by utilizing this strategy, they may be more likely to lower their threat point by accepting a lesser amount.  These transaction cost are expensive and makes it more difficult to find the cooperative solution.  Plaintiffs may not know how much an insurance company is willing to settle a case for thus they must try to find the threat point.  This costs money and time to find this information out.  Additionally there is the uncertainty of how the jury will rule.

Another obstacle to bargaining occurs when one or both parties become unreasonable or hostile to each other.  Thus it becomes more difficult to determine how the surplus should be split up.

Bargaining will be cooperative more often when rights are clearly established.  Using game theory language, if threat points are public knowledge an agreement is more likely.  An example of this is when banks let consumers know through advertising what they are charging for a loan.

This public information idea explains why when we buy property, a legal title search tells us who owns the property and if it is theirs to sell.  This is easy to confirm.

Finding a cooperative solution requires bargaining, which can be very expensive.  Communications between parties is also costly. If a geographic area has few people then a solution will be made more quickly.  If there are many parties to a dispute who are located in many far away areas communication costs can be tremendous.
Can anyone think of types of cases that are being publicized now that appear to be unfair to people but very lucrative for attorneys which may have large communication cost?
Class action suits!  Attorneys must take advertisements out in many local papers and local TV stations all over the country to let people know that they might be able to be part of the class action law suit.
For example, when an attorney calls for a client they charge the client as if they had to call many people all over the country (sometimes multiple times) to coordinate a meeting.  This process can be very expensive.

Can anyone think of a situation where transaction costs will be high because two parties to the dispute are being unreasonable or hostile in trying to divide the surplus from cooperation?

Divorce is an example of how unreasonableness between the parties in dividing the surplus from cooperation can become expensive.  There can be emotional concerns that prevent one party from making rational strategies.  Each side may push the other side to hard for their own self-interests and as a result they can't agree.   Since the parties are so hostile to each other they can’t decide how to split the surplus, which is generally know through tax returns and financial statements.  Notice when divorce is uncontested it is very simple and can be done without a lawyer.  Yet many divorces go to court.

How does the familiarity of the people bargaining with each other affect transaction cost?
 
 
 
 
 
 

Cultural differences can add to transaction cost because each party is unfamiliar with the others culture and how each culture bargains.  You may do something that is not offensive in your culture but is offensive to the other party.

The premise of property law is to get both parties to agree by reducing transaction costs.

Level of Transaction Cost and the Appropriate Law
Since the efficient use of resources do not depend on property law when there are zero transaction cost, the opposite must be true.  That is, when transaction costs are not zero the assignment of property rights (through the law) is very important to efficient resource allocation.
Insert Figure 4.2 here.
 
 
 
 
 
 
 

When transaction cost are very low (each individual has a different point of view of what is low) society should let bargaining determine the efficient use of resources.  If transaction costs are high then society needs an alternative to bargaining.  That alternative is usually some legal rule.  Thus there is some point above a certain threshold of transaction costs where laws must be used to allocate resources.  Keep in mind that different people have different views of what the threshold is.  Once the parties to the dispute agree that bargaining will not work because of high transaction cost then a legal remedy is needed.
 The book has a good example of this when they discuss smoking in restaurants.  Should restaurants decide themselves about allowing smoking or should their be a legal regulation about smoking in public?  If you believe bargaining between restaurant owners, smokers and non-smokers can be accomplished then let the three parties deal with it.  No matter what they come up with the most valuable use of the restaurant will prevail.  On the other hand if you think that the transaction cost will be to high then government can make laws to solve the problem.  Think of the new antismoking law in New York State.
 It is possible that a restaurant owner would want the government to settle the dispute because they are afraid that no matter what they do they will loose customers and people will be unhappy and it will effect their business.  Consequently, when the government creates a law saying you can’t smoke that implies transaction costs were too high.

Normative Coase and Hobbes Theorems.
Hobbs came up with a principle called the Normative Hobbes Theorem: Structure the law to minimize the harm caused by failures in private agreements.  Essentially, this says that when making law it should be made such that it is not a big problem if people do not agree.  The law should be made so that threats of disagreement are small.  Thus, if two parties are negotiating a contract over lending money to buy a house and if one party does not like the interest rate, the law should be made such that the bank cannot threaten the borrower physically for not taking the loan.  If the parties do not agree and the borrower takes the loan from someone else its not a big deal.  Or if the borrower can't get a loan then there is nothing really destructive going on.  The law should minimize the damage from not agreeing to the terms of the loan.

Review of Hobbs Normative Theorem

What is Hobbs Normative Theorem?
 
 

Can anyone think of an example where the Hobbs Normative Theorem is violated?
Suppose we lived in a corrupt society and you tried to get a loan from a bank.  Assume that the bank is owned by the family of a dictator who grants the licenses to operate the business you want to start.  If you do not take the loan at a much higher interest rate from the dictator’s bank you can not get a license to operate your business.
 

What is the Normative Coase Theorem?
 
 
 

Why do we call it normative?
 
 

The two normative principles of property law

1.  Hobbs minimize the harm caused by private disagreement over resource allocation and

2.  Coase minimizes the obstacles to private agreement over resource allocation.
 

Both of these in essence are the basis of economic analysis of property law.

The essence of all this is that the rule of law dealing with property should be made so that resource can be transferred from one party to another by facilitating private bargaining.  If the law encourages private bargaining then resources will be transferred in an efficient manner.

If a law lowers transaction cost it is said to lubricate the bargaining process.  One way the law accomplishes this is by defining simple and clear property rights.  It is easier to bargain when things are simple and clear rather than complicated and uncertain.
 We have discussed that when there is a cooperative surplus both sides of the dispute will bargain over how that surplus should be distributed.  As long as the transaction costs are less than the surplus private bargaining will be efficient.  However, if transaction costs are greater than the surplus then if the private exchange between the two parties are negative and at least one party will lose from private exchange then there will not be an exchange between the parties.  No rational person will agree to something that will make him or her worse off, thus if the net benefit of exchange is negative (transaction > surplus) private exchange will not occur.
 If the surplus is greater than the transaction costs, bargaining between the parties will occur and there will be a transfer ownership to that party that values it the most.  Of course this was discussed in a world of zero transaction costs.  If there are positive transaction cost the law should be made to lubricate private exchange by lowering the transaction cost. If transaction costs are greater than the surplus (thus preventing trade) the law can reduce transaction cost until they are smaller enough to make the two parties trade.

Providing lots of information to the public is one way of doing this.  The new law in New York State about leasing cars has accomplished this.  Prior to this law many consumers would have to spend a lot of time (or hire someone) to calculate the true cost of leasing a car.  Now in NY when you sign the lease all the up front and total charges must be made available to the consumer.  This is a law reducing transaction costs.
 If the transaction costs > surplus and the law can’t lower transaction costs, then the law can actually transfer the property to that party who values it most.  That is, the law reallocates legal rights from the party who values them less to the party who values them more.  If the law reallocates property rights, then private exchange is not necessary.   Unfortunately, lawmakers often do not know who values property the most and finding out is difficult to do.  Both sides are likely to exaggerate their losses or underestimate their gains.  So lawmakers are faced with a tradeoff between transaction cost and information cost.  Remember the state will incur the information cost.    A court can follow past precedent and avoid all information costs of determining who values a right more and let the parties take care of all transaction cost of trading, if trading is going to take place.  Or the courts can determine who values the land the most and incur that cost and thus relieve the parties of their transaction cost.
The Supreme Court recently ruled in a case that it doesn’t matter what the cost to the firm is or the cost of cleaning up the environment.  The air must be clean regardless of the cost to the firm.
What does efficiency require the courts to do?
 
 

Thus if Information cost IC < transaction cost TC
IC<TC the courts should allocate the legal right initially to the person who values it the most.

If TC<IC they should strictly follow precedent.
 
 
 

 HOW ARE PROPERTY RIGHTS PROTECTED?

We now want to examine how remedies for violating property rights are determined when someone interferes with those property rights.  That is, what are the remedies for violating property rights?  This is one of the questions property law has to deal with that we discussed before.

Common law has two types of remedies when someone interferes with another person’s property rights.  There is either a legal remedy or an equitable remedy.

What is a legal remedy?
 
 
 
 
 
 

Suppose the legal remedy under-compensates the plaintiff for the damage done to her.  For example, the defendant did not enough insurance to cover the losses of the plaintiff.  Or suppose someone trespassing on your property or preventing you from using your property.  A fine does not bother them and they continue to interfere with the use of your property.
When this occurs then equitable relief may be used.

What is equitable relief?
 
 

This is more serious because if you disobey an injunction you can be put in jail for not following the injunction regardless if you were guilty or not.

Courts do not like to use equitable relief except in property law.

The reason courts do not use equitable relief often in contract or tort law is because they believe money often compensates the plaintiff for the damage done to them when dealing with breaking a contract or harming someone.
 Courts do not want to get into a confrontational situation because the consequences of disobeying an injunction are so severe.  Property law often uses equitable relief because trespassing and interference with the use of ones property often become an important factor.  When this occurs a fine may not be enough to prevent one party with interfering with your rights to your property.  Thus, courts issue injunctions, which prevents the other party from interfering with your property rights.  If you violate the injunction the court can put you in jail.
What do we mean when we say legal relief  (fine) is “Backward-looking?
 
 
 

What do we mean when we say equitable relief (injunction) is “forward-looking”?
 
 

 Which remedy, legal or equitable, is better from an economic point of view?  The book has the example of the Electric Company that releases smoke that dirties the wash of the Laundry.  (In this example I always wondered why not use dryers rather than hanging the cloths outside?)
 

We already discussed how the law affects the distribution of the cooperative surplus, which then alters how the parties bargain.

That is, the legal remedy effects the bargaining between the two sides. When bargaining occurs each side wants their threat value plus as much of the cooperative surplus as possible.  Thus, one would think that a 50/ 50 split of the surplus might appear to be the best distribution of the surplus.

Suppose there are two legal remedies of how the surplus should be split.  One possibility is a legal remedy that splits the surplus (money damages) 30% to one party and 70% to the other.   The equitable injunctive relieve might make the split 60% to 40%.   Even though both parties agree to cooperate, the legal remedy affects the distribution of the cooperative surplus because they will bargain knowing what the legal splits might be.

The law affects things besides distribution, the law affects the probability of the negotiations succeeding and it takes into consideration the consequences of failing to agree.  For example, if you plan on building an addition to an apartment house that you own but need to build it 3 inches across the property line in order to get one more unit built that generates $500 a month income.  Suppose you did this thinking that the law was compensatory (legal remedy) and you estimated that a court would make you pay your neighbor $2000 if they found out you went over the property line.  Suppose you get caught and you sit down with your neighbor to negotiate damages.  However, the law says that instead of a legal remedy of a fine an equitable solution is required.  An injunction is issued preventing you from renting any of the apartments in the new addition.  Suppose the apartments yield $4000 per month.  As you negotiate you will be very aware of the different costs imposed by the law.  One cost is a $2000 fine while the other cost is lost revenue of $4000 per month.  You will look at the probability of successfully negotiating a settlement, which will remove the injunction.  You will compare this to the cost of failure to negotiate a settlement.
 Thus depending on how the law issues its remedy the probability of you negotiating a settlement is effected. You then compare that to the cost of failing to reach an agreement.
Thus the courts can influence the outcome.  The courts must find some method of choosing between compensatory damages and injunctive relieve based on the parties ability to cooperate in resolving the dispute.
 A rule for the courts to follow is the following:
1.  When there are high transaction cost to cooperation the court should use compensation to remedy the interference with the plaintiffs property.

2.  When there are no transaction cost and no obstacles to cooperation then the court should issue an injunction.

This concept was first stated by Calabresi and Melamed in their article Property Rules, Liability Rules and Inalienable: One view of the Cathedral.

Think about this rule very carefully.
 If there are few  (or no) transaction cost to cooperation then a court should issue and injunction rather than a fine.   This means that since there are few transaction costs to effect bargaining, negotiating between the parties should be relatively easy to accomplish.  Thus if for some reason the parties fail to agree then the law should be equitable and issue an injunction.
 Notice that this is a very severe remedy that sends the following message.  Since the two parties should be able to agree to a solution because of low transaction cost. And for some reason you were being stubborn and are going to waste the courts time the court will issue a very severe penalty and grant an injunction preventing one of you from doing something.   Yes, the court says, we understand it is a harsh penalty but we also understand that since transaction cost were low you should have been able to agree on your own, but you couldn’t so we will make the decision for you by granting the injunction.

Explain how this is the same situation as the positive Coase theorem?
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

An example is the following.  Suppose property owners are very close to each other (the two neighbors in our apartment example) there really should be no transaction cost of communicating to each other and they should be able to agree to a bargain.  If they can not agree then an injunction to put the addition back three inches could be issued. If you were the person who initially offered $2000 to the neighbor and your neighbor rejected it, now might be the time is right to raise the offer.  This is precisely what you would want the law to do.

Before we said bargaining is more successful when the legal rights of the parties are clear and simple.  Notice an injunction is about as clear and simple as you can get.  It tells you to stop or to do something.  Can’t get any simpler.  Awarding money damages by the court is very unpredictable.

Why do you suppose awards of money damages are unpredictable?
 
 
 
 
 

Suppose a satellite goes off course in space and interferes with the orbit of another satellite. It will be difficult for a court to assign monetary value to the damage done.  An injunction saying to remove the satellite or shoot it down gives the parties a clear position to bargain from.  You know how much that satellite cost you and if you must remove it you know the loss.  Any agreement you reach with the other side that is cheaper and therefore more efficient.

On the other hand, if high transaction costs make it difficult to cooperate an agreement will most likely not occur.  The courts then should award compensation (money) for failing to agree to a solution.
 For example, suppose there was a big dispute between 15 different corporation from around the world with respect to a property issue.  It would be very difficult to get everyone to even agree to a time to meet let alone agree on something very complex.  The transaction cost of communication will be high and monitoring is costly.  Additionally, each party in the negotiations would be using strategic behavior, which is expensive.  In this type of situation courts should award compensatory damages for failure to agree.
 

Reviewing the Calabresi and Melamed rule:

1. Where there are obstacles to cooperation (i.e. high transaction cost), the more efficient remedy is the award compensatory money damages.
2. Where there are few obstacles to cooperation (i.e. low transaction cost), the more efficient remedy is to issue an injunction against the defendant’s interference with the plaintiff’s property.

Calabresi and Melamed say that when cooperation is unlikely the court can use a make-believe market analysis to efficiently use resources to remedy property disputes.

How would this be done?
 
 
 
 

Economic theory does this all the time.  When we talk about monopoly didn't we compare the monopoly price to the price that would exist under perfect competition and then say the government should regulate the monopoly as if a perfectly competitive price existed.  It is that very economic logic that is being used in law.

Their terminology is if a private bad (harm that affects few people) is caused by an eternality then, an injunctive remedy should be used.  If on the other hand, a public bad (harm that affects many people) then if an externality exists the remedies should be monetary damages.

Just having a threat of an injunction will usually provide the incentive for the party of up the offer enough to compensate the plaintiff.

WHAT CAN BE PRIVATELY OWNED?

We already discussed how property rights can be protected by the two types of remedies (fines or injunctions) available to the courts.  Now we need to determine if property rights should be privately or collectively held?  This is another of the four fundamental questions of property law, what can be privately owned?

Some resources are private and that some resources are public.

What is the difference between them?
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

How can we relate private to public goods in terms of efficiency?   Efficiency requires that those people who value it the most consume private goods.  Efficiency tells us that a private good is efficient if it is privately owned.  This occurs because there is rivalry for the product between people and the owner of the product can exclude someone else from using it.    Thus a single individual or a small group can control goods.  We know that when only a few people are involved in a dispute it is easy (low transaction costs) for each party to reach an agreement.  Thus goods that show rivalry and exclusion should be privately owned and is efficient.

Why would it be efficient to allow large groups to own public goods?
Public goods do not have any rivalry and it is hard to exclude people from using it.   It would be very expensive to exclude anyone from using a public good, thus it makes sense to allow large groups to own public goods because it will be cheaper (hence efficient).

Thus goods that have rivalry and exclusion of others should be privately owned.  Those who value it the most will eventually end up owning it.  The market system will allow exchange of these private goods to occur because those who value it most will buy it.

The law helps achieve an efficient allocation of private goods by lubricating the bargaining process.  It accomplishes this by lowering bargaining cost by assigning simple and clear ownership rights.  Once everyone knows who legally owns the good, then it will eventually go to that person who values it most.

 Usually public goods can not be provided in the market place. If the private sector tried to provide public goods supply will be very small, because we cannot eliminate the "free rider" from taking advantage of the public good without paying for it.

What is a free rider?
 
 
 
 
 
 
 
 

How is the free rider problem remedied?

This problem is remedied by either the government paying for the good from general revenues or letting a private concern provide the good with the government subsidizing it.  Space technology is often done this way a private company builds the space ships while the government subsidizes the company.

Usually public ownership of private goods misallocates resources because the resource does not go to its most valued use.  Deregulation of the electric, airline or any industry is based on the idea regulation is interfering with resources going to the most highly valued use. Instead of lubricating exchange regulation directly determines the exchange which is not efficient because the person who values it the most does not get it.
 

Government’s role with respect to private goods is to make a law that lets the Hobbs and Coase normative principle expedite the working of the market system.
 
 

We will now talk about property rights as an intangible asset; information is such an asset.  Think of the Internet and all the information on it.  Who is entitled to own that information and how do we protect it for them?  First, the creation of information is very expensive, so if someone wants to create information they certainly would want to be able to get the rewards from that information.  While it is costly to produce information it is very cheap to transmit.  Once information is sold to one person that person can become a competitor or just give it away.  People will be "free riders" for the information and just pay the transmission cost of it, which is very little on the Internet.  Have you ever copied for free a computer program or a friends CD or videotape?

How is information like a public good?
 
 
 
 
 
 

The result of this problem is that the private sector in a market system will not supply enough information.  That is, the market will not produce the appropriate amount of information, this is called the problem of non-appropriability.

Traditional economic analysis suggest that free markets (unregulated by the government) will produce sub-optimal amounts of information, and that the government should intervene in the market to make sure that enough information is produced.

As with any public good this can be done by either the government producing the information itself, or subsidizing the private provision of information.

Government funded research is an example of this. The government gathers data and sells it cheaply or awards monopoly rights to people who create the information through patents, copyrights and trademark systems.

Even though theory suggests a sub-optimal amount of information will be created in a nonregulated market another theory suggest just the opposite.

Suppose you create a new way of traveling the Internet and give it away free. This new information, which you are giving away, will allow everyone to use it.  As a result they learn your program.  Since everyone is using your product for free you can sell him or her other products and profit by this information.  Suppose you create a better way of predicting the stock market.  You created this information, but you use it yourself to generate large profits.

Other economists have argued that competitive markets produce too much information.  Many firms researching a cure for cancer will duplicate research, which leads to an inefficient use of resources.

What can owners do with their property?

People should be able to do anything they want with their property as long as it does not interfere with other people’s property rights.    If there are externalities from someone preventing others from using property, the other party is occurring an external cost.  When externalities exist, private bargaining will not solve the externality problem.  In a sense externalities are like a private good, except it is bad so it is called a private bad.  When we discussed public goods we said bargaining will not work because of the free rider problem.  The same holds true for a public bad or externality.

Why is that so?
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Distribution
Thus far we have been talking about the efficiency criterion of property law but we never really talked about how property should be distributed.
Keep in mind that most of our efficiency analysis actually relied on the use of common law.  That is, judges as long as they use the proper economic analysis will be able to make the correct decisions with the implicit threat of a fine or an injunction as the final outcome.  Thus common law is making everything work. There is no need for the government to create new statutes, which require a lot of political actions to get the statutes passed.  This way of thinking is attributed to the Chicago Law school.
Distribution becomes a political question, which no longer requires common law but instead requires government agencies and statutes to help with the redistribution.  When market failure leads to a very poor distribution of resources then government institutions along with new statutes and regulatory agencies becomes important.  This line of reasoning is often attributed to the New Haven School (Yale) of Law and economics.  That school examines all aspects of governmental policy not just common law as the Chicago school does.  This becomes a much more political analysis of say property law (but arguable much more realistic). Depending which side of the street you are on will determine how you feel about it.  Some people feel the government should redistribute wealth for the sake of social justice where others believe this should not be done.
 Most economists agree that government redistribution of wealth should be done through a progressive tax system rather than by rearranging property rights.  The main reason for this is that once the government tries to reshuffle property rights it will create transaction costs which will mean that those who are getting the property are getting less because the transaction cost are a drain on resources.