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Econ 522 – Lecture 5 (Sept 20 2007)
Today: More Property Law – Transaction Costs, etc.
Yesterday, we introduced Coase, and the result known as the Coase Theorem or Coase
Conjecture: that when the cost of private negotiations are zero, they will lead to efficient
outcomes, regardless of initial allocations of property rights or liability. Or, to put it in a
market context, that when the costs of transacting are zero, that externalities can be
overcome (and efficiency restored) by making property rights more complete.
However, our statement of the Coase Conjecture immediately suggests the converse:
when private negotiations are not costless, or transaction costs are not zero, that initial
allocations will matter for efficiency. This happens for two reasons: first, when
transaction costs are high, they will block certain trades that would have been beneficial;
and second, even when transaction costs are low but not zero, any resources spent
actually transacting are, in a sense, resources wasted.
Coase again: “If market transactions were costless, all that matters (questions of equity
apart) is that the rights of the various parties should be well-defined and the results of
legal actions easy to forecast. But as we have seen, the situation is quite different when
market transactions are so costly as to make it difficult to change the arrangement of
rights established by the law. In such cases, the courts directly influence economic
activity. It would therefore seem desirable that the courts should understand the
economic consequences of their decisions and should, insofar as this is possible without
creating too much uncertainty about the legal position itself, take these consequences into
account when making their decisions. Even when it is possible to change the legal
delimitation of rights through market transactions, it is obviously desirable to reduce the
need for such transactions and thus reduce the employment of resources in carrying them
out.”
Coase offers two examples of institutions that may emerge in response to high transaction
costs: firms, and government regulation. Going back to his example of a farmer and a
rancher, if for whatever reason it is very difficult or costly for them to come to an
agreement among themselves, one solution is for the ranch and the farmland to be both be
purchased and operated by the same firm, so that the firm balances the costs and benefits
of both activities and maximizes the total value of production. The second example,
government regulation, is the same idea, since he imagines the government as a sort of
“super-firm” which considers the costs and benefits of each activity to everyone.
Transaction Costs
So, what are transaction costs? Transaction costs are anything that makes it difficult or
expensive for two parties to achieve a mutually beneficial trade. Cooter and Ulen divide
them into three categories:
 search costs – difficulty in finding a trading partner
 bargaining costs – difficulty in reaching an agreement on the terms of the trade
 enforcement costs – difficulty in enforcing the agreement afterwards
Search costs are self-explanatory. When we think of common, standardized goods, there
are likely lots of buyers and lots of sellers, so it shouldn’t be hard for them to find each
other. When we think of rare or exotic goods, search costs may be very significant.
Bargaining costs are a little less obvious. We used the example before of my car being
worth $3000 to me and $4000 to you. Once we find each other, all we have to do is
haggle over price and agree on something in the middle – doesn’t sound so hard.
However, this assumed that both of us knew exactly how we valued the car, and knew
each others’ threat points. When these assumptions fail, things get more complicated.
First of all, there’s the possibility that I know something about the car that you don’t.
I’ve been driving it a while, I might know that the transmission is about to fail, or that it
needs new brake pads, or that it doesn’t start well on cold mornings. So you might worry
that if I’m willing to sell it to you for $3500, maybe it’s because there’s something wrong
with the car. So one aspect of bargaining costs might include taking it to a mechanic to
verify its condition and try to get an objective measure of the value of the car.
Next, even if we agree on the physical condition of the car, I might not be sure exactly
how badly you want it. Suppose the car is worth $3000 to me, and $3100 to you, but I
don’t know what it’s worth to you – all I know is that you value the car at somewhere
between $3000 and $5000.
Since you value it at more than $3000, there are definitely gains from trade – it’s
definitely efficient (and Pareto-improving) for me to sell you the car. But now you try to
convince me that the car’s only worth $3100 to you, and that I should therefore sell it to
you for $3050. But here’s the problem: anything that you say to try to convince me, you
could also say if the car was worth $4000 to you, and I have no way of knowing whether
you’re telling the truth or lying to get a better deal. So if I give in and sell you the car for
less than $3100, I can’t escape the possibility that I’d also sell you the car at that price if
you valued it at $4000. So I end up saying, “Maybe you’re telling the truth, and maybe
you’re lying, but I won’t sell it for less than $3500.” Which means that some of the time,
even though you value the car more than me, we don’t reach a deal.
There’s a famous paper by Roger Myerson and Mark Satterthwaite, “Efficient
Mechanisms for Bilateral Trade,” which shows that when there’s private information of
this sort, there is no way to guarantee that the efficient outcome will always be reached –
there’s always some probability that an inefficient outcome (in this case, no trade) occurs.
In this case, bargaining fails because we don’t agree on what each of our threat points are,
that is, our threat points are not common knowledge. There have been a number of
papers on bargaining, both theoretical and experimental, that reinforce the fact that
people are more likely to come to agreements when they know each others’ threat points.
One interpretation of threat points being private information is simply that tastes are
subjective – I don’t know how much you like the color of my car, for instance. But
another source of uncertainty about threat points is when property rights themselves are
ambiguous. If we consider again the problem of the rancher and the farmer, and suppose
that the efficient outcome is for the farmer to build a fence to protect his crops. But now
suppose that the property rule (or the liability rule) is ambiguous – whether or not the
rancher is liable for his crop’s damage is open to interpretation, or depends on the exact
details of the situation, so the court’s decision is unpredictable. In that case, the rancher
and the farmer might not agree on what would happen if no fence was built; and so each
one might be uncertain about the other one’s threat point, and therefore it might be very
hard for them to come to an agreement. This is one of the arguments for clear, simple,
well-defined, unambiguous property rights – that they make negotiations easier, that is,
effectively lowering transaction costs.
There’s another way in which bargaining can be difficult, or even impossible, which is
when instead of a single buyer and a single seller, there are many parties to the deal. This
is one of the situations discussed in the paper by Calabresi and Melamed.
Suppose there’s a developer, who wants to build a shopping mall, and he values the land
he wants to build on at $1,000,000. Now suppose there are currently 10 houses on that
land right now, and each homeowner values his property at $80,000. Clearly, there are
gains from trade: the combined value of the plots is $1,000,000 to the developer, and
$800,000 to their current owners.
But now think about one of the homeowners. He thinks, “If we all sell our land to the
developer, this creates $200,000 of surplus. I don’t mind if all my neighbors sell out
cheaply, but I want a piece of that!” And he figures that he’s the only one smart enough
to ask for more money, so he asks for $120,000, figuring that still leaves the developer
with a big enough surplus. And now some of his neighbors do the same calculation, and
ask for more money for their land. And since it’s very hard to negotiate with 10 people at
the same time, negotiations may fail.
(One of the papers I’m working on is a game-theory model of many-to-one bargaining.
The idea is this. Everyone accepts that if 9 of the homeowners have sold out to the
developer, the last guy is in a pretty strong bargaining position, so he can probably get a
pretty high price for his property. But since everyone knows that, nobody wants to be the
first to sell out – they’d rather wait for their neighbors to sell, and then be the last, so they
get a better price. So even when cooperation, or trade, is efficient, and might occur
eventually, there can be huge delays before the trade happens, due to everyone waiting
around hoping to be last.)
And the same thing can happen when there are many buyers instead of many sellers.
Suppose that instead of a shopping mall, the land was being bought up to be turned into a
park, that would benefit 10,000 people in the community, and each of them would
receive benefits worth $100 from the joy of having the park. Even if the homeowners
were all willing to sell for $80,000, or $800,000 total, it might be impossible to raise that
much through voluntary contributions, since each citizen might think, “We only need to
raise $800,000, and all my neighbors should be willing to pay $100, so even if I don’t pay
anything, the park should get built!” This is the problem of freeriders – once the park is
built, its use won’t be limited to the people who paid for it, so people may try to avoid
paying, preferring to get the benefits for free.
So when negotiations need to take place between lots of people, rather than just one
buyer and one seller, there is a risk of both holdout – individual sellers holding out for
high prices – and freeriding – individual buyers trying to get the good for free – that may
cause negotiations to fail, or to take a long time to conclude. So these can be thought of
as bargaining costs.
(One final source of bargaining costs is hostility. Many divorce agreements end up being
settled by litigation, which is more costly than negotiation, not because the parties
disagree about their threat points or for any other rational reason, but because the parties
are angry with each other and don’t want to come to a rational agreement.)
The final type of bargaining cost that Cooter and Ulen consider is enforcement costs.
Obviously, if I’m just buying an apple from a fruit stand, there are no enforcement costs –
I give him my money, he hands me an apple, and the deal is done. But think about our
example from before, of a rancher and a farmer. Suppose that even though the rancher is
not liable for his herd’s damage, it’s cheaper for him to fence in his herd, so the farmer
pays him to build a fence. But now the farmer has to make sure that he actually builds it,
and maintains it – the deal is part of an ongoing relationship, and has long-term
consequences. In the case of pollution rights, if a factory pays for the right to pollute a
certain amount, or neighbors pay a factory not to pollute in excess, someone has to
monitor the factory and make sure they abide by the agreement. This involves ongoing
costs.
So now, let’s recap what we know. Coase tells us that when there are no transaction
costs, the initial allocation of property rights (or liability) doesn’t matter for efficiency,
since people will trade until efficiency is reached. On the other hand, Coase tells us that
when transaction costs are high, the initial allocation is important, since trade may not be
feasible. This leads to two different notions of what the goal of property rights should be:
1. Structure the law to minimize transaction costs.
Cooter and Ulen phrase this as, “structure the law so as to remove the impediments to
private agreements,” and refer to this as the Normative Coase Theorem. If the law is able
to reduce transaction costs, then voluntary exchange will be more likely to lead to
efficiency. Cooter and Ulen refer to this as “lubricating” bargaining – making it easier
for bargaining to proceed without costs.
We said before that one source of bargaining costs is uncertainty about threat points; this
suggests that bargaining costs are reduced when the law is simple and unambiguous, so
that everyone is clear about everyone’s rights. This seems to favor rules like fast
fish/loose fish and allocating the fox to Pierson, the guy who actually killed it – these are
simple rules, there is little to dispute once the rule is established, and this should make
both sides’ threat points clear and encourage trade to occur when it is efficient.
However, this is not the only possible goal of the law. Like we said, when transaction
costs are high, the initial allocation matters for efficiency; so a different conception of the
goal of the law could be,
2. Structure the law so as to minimize the harm caused by failures in private
agreements.
Or really, structure the law so as the make the allocation more efficient to begin with, so
that fewer negotiations are required and their failure is less costly.
This goal was put forward by Hobbes, who felt that people could not be counted on to be
rational enough to cooperate. This view of the law is the Normative Hobbes Theorem,
and suggests that the law should aim to allocate property rights to whoever values them
the most, so that transaction costs become irrelevant and efficiency is achieved.
This seems to favor rules like iron-holds-the-whale and giving the fox to Post, who was
chasing it, as a means of providing better incentives, leading to efficiency without
bargaining.
So now we have two possible guidelines for what property law should aim to accomplish
– one, lubricate private transactions, and two, allocate rights to whoever values them
more. So now we have to ask, when is one of these aims appropriate and when is the
other? We can answer this by thinking about the cost of each guideline.
When transaction costs are reduced, they are still unlikely to be eliminated – that is,
lubrication works to a point, but there will still be some transaction costs remaining.
When these are low, efficiency will nearly be achieved; when they are still high, the
outcome may still be very inefficient.
On the other hand, in order to start out at an efficient allocation, lawmakers must figure
out who values a right more highly. This is not always obvious. So we can imagine the
lawmakers must face some sort of Information Costs to come to the correct conclusion.
(This can be thought of either as costs they actually incur in researching the situation, or
as the costs of being wrong some of the time.)
Which brings us to the principle reached by Cooter and Ulen:

When transaction costs are low and information costs are high, structure the law
so as to minimize transaction costs

When transaction costs are high and information costs are low, structure the law
to allocate property rights to whoever values them the most
Next, will take on the question of how property rights are enforced, that is, what remedies
are used when rights are violated. This is what is dealt with in the paper by Calabresi and
Melamed, “Property Rules, Liability Rules, and Inalienability: One View of the
Cathedral.” Calabresi and Melamed state that their goal is to treat both property and
liability law under a common framework, rather than keeping them as distinct topics.
We’ve already been doing this: when we think about the rancher-farmer question, we can
pose it in terms of liability – is the rancher liable for the damage his herd does? – or in
terms of property – does the farmer’s right to his property include the right to be free
from trespassing cows? or does the rancher’s right to his herd include the right to not be
punished when they stray? Calabresi and Melamed consider both cases to be cases of
“entitlements” – is the farmer entitled to land without trespassing animals, or is the
rancher entitled to be free from herd-damage liability? Similarly, am I entitled to have a
noisy party, or is my neighbor entitled to be undisturbed by my noise?
Calabresi and Melamed discuss three possible enforcement rules for protecting an
entitlement.
1. Property Rules, or Injunctive Relief
These are when you are legally barred from violating my entitlement without my prior
agreement. This is the usual rule for protecting private property – if it’s mine, you simply
can’t take it unless I give it to you. (And if you do choose to take it, you’ve committed a
crime – you don’t just owe me the value of what you took, you may go to jail, you may
face other consequences.)
An injunction is basically a court order clarifying someone’s rights and specifically
barring someone from violating them. For example, if a factory is polluting and the
neighbors object and take it to court, the court might issue an injunction, which would bar
the factory from further pollution. The factory could still negotiate with the neighbors
and reach some bargain where the neighbors agree not to enforce the injunction, but this
would be completely at the discretion of the neighbors.
2. Liability Rules, or Damages
These are when you can violate my entitlement without my agreement, but must
compensate me after the fact for whatever damages I incur.
Under a liability or damages rule, the factory could go on polluting, and the neighbors
would sue them for damages; the court would then have to calculate an objective value of
the damage done. The neighbors can argue that the damage incurred was high, but they
are only awarded what is considered fair value, not what they argue they would have held
out for in the beginning.
This is the type of rule behind eminent domain. If the government wants to build a
school, or an army base, or a town dump, on land that I own, they can force me to sell;
and they can force me to sell at what is considered fair market value, not to hold out for
whatever amount I want based on my sentimental attachment to the house I grew up in or
anything else. Liability rules obviously work better in settings where prior negotiation is
impossible – clearly, I have an entitlement to not be hit by someone’s car when I’m
walking, but it’s hard to imagine them approaching me beforehand and bargaining for the
right to hit me.
(Damages are backward-looking – they compensate for harm already done, while
injunctions and property rules are forward-looking – they specifically forbid future harms
from occurring.)
A property rule will always be more favorable toward the injuree (the person whose
entitlement is to be violated), and liability rules are more favorable toward the injurer.
This is because the punishment for violating an injunction without the other side’s
permission is much harsher than damages, since it may involve criminal trespass or
violating a court order – so when the two sides bargain, the injurer will have a much
lower threat point when facing an injunction, so the injuree will end up with a higher
payoff if they do choose to cooperate. (We’ll see an example.)
In a world without transaction costs, either rule should be sufficient to allow private
bargaining to lead to efficiency; however, since the two rules change the two sides’ threat
points, they change the payoff achieved by each side during negotiations. In a world with
transaction costs, of course, they may lead to different results. Consider the example in
Cooter and Ulen.
There is an electric company E that emits smoke, which dirties the laundry at a
laundromat L next door. The electric company earns profits of 1000, and could stop
emitting smoke by installing scrubbers in its smokestack, at a cost of 500.
Without smoke, the laundromat earns profits of 300. Smoke does $200 of damage
(reducing profits to 100). The laundromat could also avoid the damage by installing
filters on its ventilation system, at a cost of 100.
Let’s look at the noncooperative results under different legal rules:
Polluter’s Rights:
E earns 1000, L installs filters and earns 200
Pollutee has right to Damages:
E earns 800 after paying damages; L earns 300
Pollutee has an Injunction:
E installs scrubbers, earns 500; L earns 300
Clearly, the efficient outcome is for L to install filters, leading to combined profits of
1200. (This avoids $200 in damage at a cost of $100, and is the cheapest way to avoid
the damage.) This is the outcome that occurs in the Polluter’s Rights case. In the other
two cases, the noncooperative outcome is inefficient; but if there are not transaction
costs, the two sides could always negotiate an agreement to achieve efficiency. But the
threat points would be very different, so the division of surplus will be different under the
two rules.
Under Damages, the threat points are 800 and 300, and there is an additional 100 to be
gained by cooperating (avoiding $200 in damage by installing filters for $100). If we
assume these gains from cooperation are split evenly, the Damages rule, without
transaction costs, leads to profits of 850 and 350.
Under an Injunction, the threat points are 500 and 300, and there is an additional 400 to
be gained by cooperating (avoiding the damage using $100 filters instead of $500
scrubbers). If this additional surplus is split evenly, it leads to profits of 700 and 500.
Under Normative Hobbes, the initial allocation should be chosen to be efficient; in this
case, this is Polluter’s Rights. (There’s no reason for this to be true more generally, just
in this example.) Under Normative Coase, if transaction costs are lowered sufficiently,
efficiency will be reached under any of the rules; the law should be designed in a way
that makes transaction costs as small as possible. (We’ll come back to this in a bit.)
Which rule is more efficient in general? An injunction is cheaper for a court to
implement – it simply clarifies the property right, but does not have to calculate the
amount of damage that was done after the fact. Damages are more difficult for a court to
implement, since they must assess the monetary value of damage that was done. (We’ll
return to the question of how damages are computed when we get to tort law; but for
now, just realize this requires going to court, expert testimony, and a judgment.)
However, in this example, if private bargaining fails, damages lead to a more efficient
result than an injunction, and this turns out to be true more generally. This leads
Calabresi and Melamed to the following conclusion:
When transaction costs are high (or there are impediments to private negotiations), a
liability rule (damages) is more efficient
When transaction costs are low (or private negotiations can be expected to succeed), a
property rule (or injunctive relief) is more efficient
(Why liability is more efficient when bargaining is likely to fail: if no agreement, the
injurer can still choose to injure and pay damages, which in this case is cheaper than
preventing the harm himself; with an injunction, he has to prevent the harm himself, even
if this is more expensive.)
Cooter and Ulen use this to explain how things are typically done in certain types of
disputes. “Private bargaining is unlikely to succeed in disputes involving a large number
of geographically dispersed strangers because communication costs are high, monitoring
is costly, and strategic behavior is likely to occur. Large numbers of land owners are
typically affected by nuisances, such as air pollution or the stench from a feedlot. In
these cases, damages are the preferred remedy.” On the other hand, property disputes
generally involve a small number of parties who live near each other and can monitor
each others’ behavior easily after reaching a deal; so injunctive relief is usually used in
these cases.
Cooter and Ulen also point out, though, that in the first case – where transaction costs are
high, so bargaining is likely to fail – a liability rule is only efficient when the court is able
to correctly calculate the amount of damages. On the other hand, injunctive relief is
efficient any time the court can determine who values the right more, regardless of its
absolute level. This leads them to a different interpretation of efficient remedies in the
high-transaction-costs case:
“When transaction costs preclude bargaining, the court should protect a right by an
injunctive remedy if it knows which party values the right relatively more and it does not
know how much either party values it absolutely. Conversely, the court should protect a
right by a damages remedy if it knows how much one of the parties values the right
absolutely and it does not know which party values it relatively more.”
And in the latter case, injunctive relief is assumed to be more efficient because it tends to
be simpler and clearer and therefore more likely to encourage negotiations. However, as
we discussed before, successful negotiations generally require clarity over each side’s
threat point. In the case of the electric company polluting near the laundry, the cost to the
electric company of complying with an injunction might not be known to the laundry,
and this could lead to difficulty in bargaining. On the other hand, efficiency of a
damages remedy would require the electric company to know how much damage the
laundry would sustain, so it will know the laundry’s threat point in order to negotiate to
have the laundry install filters. This leads Cooter and Ulen to restate the second rule:
“Where there are few obstacles to cooperation (i.e., low transaction costs), the more
efficient remedy is the award of an injunction when the plaintiff can estimate the
defendant’s compliance costs more readily than the defendant can estimate the plaintiff’s
damages.”
Calabresi and Melamed defend injunctions as being optimal by assuming that the parties
will privately negotiate after the court rules. Cooter and Ulen (on their website) mention
a paper by Ward Farnsworth, examining whether this occurs.1 Quoting:
Farnsworth "examines twenty nuisance cases and finds no bargaining after judgment in
any of them; nor did the parties’ lawyers believe that bargaining would have occurred if
judgment had been given to the loser. The lawyers said that the possibility of such
bargaining was foreclosed not by the sorts of transaction costs that usually are the subject
of economic models, but by animosity between the parties and by their distaste for cash
bargaining over the rights at issue."
Naturally, Professor Farnsworth asked the lawyers why they though that no bargaining
occurred after judgment. The lawyers cited two impediments to post-judgment
bargaining. "First, in almost every case the lawyers said that acrimony between the
parties was an important obstacle to bargaining. The parties in these cases often thought
that their adversaries were behaving in ways that were unreasonable, discourteous, and
unneighborly. Frequently the parties were not on speaking terms by the time the case
was over (sometimes much earlier). ... The second recurring obstacle involves the
parties’ disinclination to think of the rights at stake in these cases as readily
commensurable with cash."
Calabresi and Melamed also talk about a third type of protection for entitlements:
inalienability. This is when an entitlement is not transferable or sellable. For example, I
an entitled to not be a slave, and I am not allowed to give away or sell that right. This
could be defended in some cases by invoking externalities; in others, it seems to be more
a case of paternalism, that is, the government thinking it knows better than you do what is
good for you. (We can think of this as the case of owning a historical landmark: it is your
property, but it may be unalienable, in that you cannot sell it to someone who would put
it to a different use.)
(ENDED HERE)
They also point out that there is a fourth option, relative to the three we showed in the example
above with the electric company and the laundry. Recall we considered the case where the
electric company was free to pollute unless they reached a bargain with the laundry not to; where
the electric company could pollute and pay damages; and where the electric company could only
pollute if they negotiated an agreement with the laundry (injunction). However, we did not
consider the case where the laundry could stop the electric company from polluting, not by
bargaining with them, but by paying objective (court-decided) damages. That is, we would start
in a world of polluter rights, but give the pollutee the right to veto the pollution and pay the
electric company for whatever losses this caused them.
(In the example we did above, this would not be efficient; but Calabresi and Melamed point out
some instances in which it might be.)
Ward Farnsworth, “Do Parties to Nuisance Cases Bargain After Judgment? A Glimpse Inside the
Cathedral,” 66 U. Chi. L. Rev. 373 (1999).
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