Property Law
The Coase Theorem
09/22/09
Prop_B
1
A Basic Question Concerning Property
Who Should Own What?
The ‘efficient’ answer:
Given the existing income/wealth distribution, the individual
who values an item of property the most.
Proof:
If there is an item of property currently owned by an
individual who does not value it the most, then that
individual can trade with an individual who values it more
and both can be better off – a Pareto improving trade can
take place.
09/22/09
Prop_B
2
If given the existing income/wealth distribution, an
individual owns an item of property that someone else
values more, we would say that there might be ‘unexploited
gains from trade’.
Unexploited gains from trade might represent unexploited
social wellbeing.
Why the might qualification? Transaction costs.
09/22/09
Prop_B
3
The Coase Theorem
An Economic Theory of Property
Bargaining theory is a very simple theory but one that leads
to an important conclusion.
If bargaining is successful then individuals come to an
agreement on mutually beneficial arrangements (the
cooperative solution) and trades takes place – property
gets reallocated
‘mutually beneficial’ implies a Pareto improvement because it is agreed to voluntarily
If bargaining fails to take place, or simply fails, then no
agreement is reached (no cooperative outcome – no Pareto
improving arrangement)
09/22/09
Prop_B
4
Is voluntary exchange the basis for all of our ‘arrangements’
(exchanges, trades, deals, agreements) in life?
No, the terms of our exchanges (interactions) can be imposed,
or partially imposed, from outside: by the law (and
related regulations)
In such situations voluntary exchange take place but with:
- no, or restricted, interaction (bargaining over only some
of the terms) between the parties
- terms of ‘cooperation’ are at least partially imposed by
some outside authority
09/22/09
Prop_B
5
Consider:
Buying health care as opposed to buying a car
Starting a TV station as opposed to starting a
newspaper
Selling legal advice as opposed to selling
management advice
Are such trades Pareto improving? YES
What’s the problem?
Exchanges under the law improve wellbeing (any voluntary
trade does that) but the welfare maximizing allocation of
resources might or might not occur.
09/22/09
Prop_B
6
Which is better: voluntary exchange or ‘the law’?
PROPOSITION: the law is unnecessary, and potentially
inefficient, in cases in which bargaining among private
parties can succeed, and the law is necessary and
potentially beneficial in cases in which bargaining among
private parties fails.
This proposition applies to all four fundamental questions of
property law:
-
09/22/09
how do property rights arise?
what can be privately owned?
what owners can do with their property?
what are the remedies for the violation of another’s
property rights?
Prop_B
7
The above proposition is known as the Coase theorem (it is
sometimes stated slightly differently)
It is the cornerstone of much economic analysis of property
and contract law
Two unstated premises of the Coase theorem:
- individuals know best what is in their own
self-interest (no paternalism – individual is sovereign)
- the distribution of wellbeing is not a consideration
(the current allocation of wellbeing is acceptable)
09/22/09
Prop_B
8
EXAMPLE: Is the law really irrelevant?
This will show the logic behind the Coase Theorem
FACTS:
Local Cable Inc operates a ground station that receives
satellite signals which are transmitted to local TV viewers
Its subscribers’ TV reception is poor whenever the microwave
communications tower on top of an adjacent building is
operating
It estimates that its loss of subscriber revenue due to poor
reception will translate into $600,000 in lost profits
Com Inc owns the microwave communication tower
The problem could be alleviated either by Local Cable Inc
repositioning its ground station or by the Com Inc building
a taller tower
09/22/09
Prop_B
9
After researching existing legislation and case law, Local
Cable’s lawyers might find:
1. Microwave communication towers are not responsible
for interference in signal transmission between satellite and
ground based receivers - ‘microwave rights’
2. Microwave communication transmitters are responsible
for ensuring that their transmissions do not interfere with
satellite to ground based receiver signals - ‘satellite rights’
3. This is an entirely new situation in the law. There is no
existing legislation or case law designed to sort out the
ownership of communication rights in public air space - ‘no
defined rights’ THIS IS A NEW FORM OF PROPERTY!
09/22/09
Prop_B
10
Under ‘microwave rights’ Local Cable might have to relocate
its ground station
Under ‘satellite rights’ Com Inc might have to build a taller
tower.
Now consider the following
- it would cost Local Cable Inc $250,000 to reposition its
ground station
- it would cost Com Inc $50,000 to extend the height of its
tower
Which law is more efficient? ‘satellite rights’ - it is less
expensive for Com Inc to extend the height of its tower
09/22/09
Prop_B
11
But consider the following situation in the next city:
- it would cost Local Cable Inc $25,000 to reposition its
ground station in the next city
- it would cost Com Inc $400,000 to extend the height of
its tower in the next city
Which law is more efficient in the next city? ‘microwave
rights’ - it is less expensive for Local Cable to reposition its
ground station
If we want to achieve efficiency, does the law (regulators or
judges) have to assess the cost conditions in each situation
in order to assign property rights?
I hope not!
09/22/09
Prop_B
12
Answer: Don’t worry, under the Coase theorem the law is
irrelevant in so far as efficiency is concerned
As long as the Cable Inc and Com Inc are willing and able to
negotiate a solution to the problem
Cooperation – successful bargaining – leads to the efficient
solution in each case, irrespective of which law applies, and
even if there is no existing law applicable to this situation
09/22/09
Prop_B
13
Proof that the law is irrelevant
in the face of cooperation – Coase Theorem
Consider the following (in the first city):
Local Cable Inc finds that Com Inc is not responsible for the
interference to its signal (‘microwave rights’). Local Cable
could:
- do nothing and lose $600,000 in profits
- relocate its ground station at a cost of $250,000 (net cost
to Local Cable $250,000)– this is the non-cooperative
solution for Local Cable
- reservation price
- or attempt to negotiate an agreement whereby it would
pay Com Inc the $50,000 to extend the height of Com Inc’s
tower (net cost to Local Cable $50,000)
What is the potential gain from cooperation? $250,000 $50,000 = $200,000 (Local Cable stands to save $200,000)
09/22/09
Prop_B
14
How would Com Inc likely view the situation?
Do nothing – don’t negotiate with Local Cable. This is the
non-cooperative solution for Com Inc.
– reservation price of Com Inc is $0
But since Local Cable Inc stands to gain $200,000 in savings if
Com Inc agrees to allow it to pay the $50,000 to extend the
tower, maybe Local Cable should try to entice Com Inc with
a share of the $200,000 in the cooperative surplus
The law (‘microwave rights’) has given Com Inc some property
rights which are worth a lot more than the Local Cable than
they are to Com Inc.
Com Inc might be willing to make a deal with Local Cable
(successfully bargain) but it might expect a share of the
$200,000 in cooperative surplus in addition to the $50,000
in costs.
09/22/09
Prop_B
15
Microwave Rights –the bargaining situation
Firm
Non-cooperative
solution
(Threat values)
Cooperative
solution
(‘reasonable’
solution)
Local Cable
-$250,000
-$150,000
(relocating the ground station)
(cost of extending tower
Cooperative
surplus
$100,000
and Com Inc’s share of
co-operative surplus)
Com Inc
Total for
Society
09/22/09
$
0
$100,000
$100,000
-$250,000
-$ 50,000
$200,000
Prop_B
16
Under ‘microwave rights’ there is a potential $200,000
cooperative surplus and this provides the incentive for
private bargaining which ultimately ensures an efficient
allocation of resources – the tower gets extended and the
ground station is not relocated
Can we really conclude that ‘SOCIETY’ is better off? YES
What if the law assigned ‘satellite rights’ in this same
situation?
What would the bargaining situation look like?
09/22/09
Prop_B
17
Satellite Rights –the bargaining situation
Firm
Local Cable
Non-cooperative
solution
(Threat values)
$
Cooperative
solution
(‘reasonable’
solution)
0
$
(must extend tower)
Com Inc
Total for
Society
09/22/09
0
Cooperative
surplus
$0
(cost of extending the tower)
-$50,000
-$50,000
Prop_B
-$50,000
$0
-$50,000
$0
18
Under ‘satellite rights’ the law allocates the resource to the
firm that values it most so there is nothing to be gained
from cooperating – no need to bargain – the tower gets
extended because Com Inc is responsible for solving the
problem
No co-operative surplus exists, WHY?
What if the law assigned ‘no rights’ in this same situation?
What would the bargaining situation look like?
09/22/09
Prop_B
19
No Rights – the bargaining situation
Firm
Non-cooperative
solution
(Threat values)
Cooperative
solution
(‘reasonable’
solution)
Local Cable
-$250,000
-$150,000
(relocating the ground station)
(cost of extending the tower
Cooperative
surplus
$100,000
and payment to Com Inc)
Com Inc
Total for
Society
09/22/09
$
0
$100,000
-$250,000
-$ 50,000
Prop_B
$100,000
$200,000
20
Under ‘no rights’ the law does not allocate the resource to
anyone so again there is a potential $200,000 cooperative
surplus and this provides the incentive for private
bargaining which results an efficient allocation of resources
– the tower gets extended and the ground station is not
relocated
The ‘new property rights’ are established through cooperative
bargaining
Conclusion: The law is irrelevant in the assignment of
property rights! It does not matter who initially has
property rights – so long as private bargaining is successful
(the cooperative solution is attained) – the tower gets
extended and the ground station is not relocated –
resources end up in their most efficient use.
09/22/09
Prop_B
21
Is this a special case? What about the other city?
- it would cost Local Cable Inc $25,000 to reposition its
ground station
- it would cost Com Inc $400,000 to extend the height of its
tower
Repeat the above analysis and convince yourself that
whatever the law is (microwave rights, satellite rights or no
rights) efficient allocation results – the lowest cost solution
to the problem will result – in this case the ground station
gets moved and the tower is not extended.
09/22/09
Prop_B
22
The Coase theorem
This was an amazing result. When Ronald Coase published
these results in the late 1950’s early 1960’s (along with
the notion of transaction costs) they were quickly
recognized as fundamentally important.
Prior to this time it was believed that property right shad to
been specifically assigned by law and that the exact nature
of the assignment would impact on efficiency – the law
had to get it right!
09/22/09
Prop_B
23
Extensions of the Coase Theorem
The Coase Theorem can be applied in a wider set of
circumstances
We will see the Coase Theorem in other contexts
09/22/09
Prop_B
24
Some comments on the above example and the
Coase theorem in general
1. The efficient outcome is assured under successful
bargaining no matter what the law states but the
individuals experience different outcomes under different
laws - there are distribution effects
2. Could we enact a law which would always allocates the
property right most efficiently and thereby eliminate the
need for the parties to bargain? Not necessarily. The most
efficient allocation of property rights depends on the ‘facts’
of the given situation.
09/22/09
Prop_B
25
3. Free versus costly bargaining: We have not considered the
resources used to bargain towards a cooperative solution.
Is bargaining free (does it have zero costs)? Never, and
bargaining can at times be very costly. Recall, these costs
are referred to as ‘transaction costs’.
We can state the following version of the Coase Theorem:
“when transaction costs are zero, an efficient use of
resources will occur through private bargaining (if
necessary) irrespective of the legal allocation of property
rights.”
Corollary to the Coase Theorem: “When transaction costs are
high enough to prevent bargaining, then the efficient use of
resources will depend on the legal allocation of the
property rights.” It might, or might not, happen depending
on the law.
09/22/09
Prop_B
26
Consider again the above communications example.
Now suppose that the cost of carrying out negotiations is
$120,000 for each side. Then Com Inc will expect to be
compensated for the cost of extending its tower $50,000,
and its negotiation costs $120,000. Its reservation price
is still $0 but now it expects Cable Inc to pay $170,000 –
before negotiations start
Cable Com stands to save $250,000 less its transaction cost
of $120,000, so that its reservation price is $80,000. But
now it must also pay the $50,000 in tower costs and
Com Inc’s transaction costs of $120,000, a total of
$290,000.
09/22/09
Prop_B
27
There is no cooperative surplus after allowance for transaction
costs - Local Cable Inc. will move its ground station at a
cost of $250,000
Successful bargaining is not possible so both agents will
simply follow the law. No attempt at cooperation is rational
(profit maximizing for the individuals involved)
In situations in which transaction costs are relatively high, it
matters greatly which agent is initially assigned property
rights
09/22/09
Prop_B
28
Transaction costs and the appropriate legal rule:
it depends!
Initial allocation of
property rights do not
matter to efficiency
Initial allocation of
Property rights do
matter to efficiency
Transaction
costs |--------------------------------------------------------|
0
∞
Intervention - the law
Allow bargaining
can improve on the
or the market
market since bargaining
will fail
Threshold level
of transaction costs
(= co-operative surplus)
09/22/09
Prop_B
29
Example: Property rights over the air we breathe
Both smokers and non-smokers want to use the same air.
Comment on the relative merits of laws which ban smoking,
as opposed to private bargaining between smokers and
non-smokers, in the following places:
-
09/22/09
public buildings
the public areas of a commercial mall
airlines, trains, buses
private business establishments
restaurants
bars
private residences
private cars
the baby’s nursery in your home
Prop_B
30
Example: Property rights over the air we breathe
Certainly individuals could agree ‘bargain over’ whether
smoking can take place. BUT what about transaction costs?
Transaction costs
-
public buildings
the public areas of a commercial mall
airlines, trains, buses
private business establishments
restaurants
bars
private residences
private cars
the baby’s nursery in your home
09/22/09
Prop_B
too high
too high
too high
market solution?
market solution?
market solution?
sufficiently low
sufficiently low
voluntary exchange
is not possible
31
In situations in which private bargaining cannot succeed, the
only way to ensure an efficient allocation of resources is
through the courts or legislatures (the law).
CONCLUSION: if the Coase Theorem applies and a cooperative
solution is possible (if a successful private bargain is
possible) then efficient resource allocation is likely to result.
BUT if the conditions for successful cooperation do not
exist, then the only possible way to achieve an efficient
allocation of resources is for the ‘law’ to mandate the
efficient allocation of the property right.
NOTE the courts and legislatures do not act like economists
whose sole objective is efficiency, nor should they. The law
has a much broader mandate: efficiency and justice, peace
and good order, etc.
09/22/09
Prop_B
32
Conditions under which the Coase Theorem
is likely (certain?) to hold
- only two parties are involved in the bargaining
- property rights are well defined
- each party has perfect knowledge of the other party’s profit or
utility function (threat values and cooperative surplus are
known)
- bargaining takes places within a perfectly competitive
framework (each side accepts all costs, savings, etc. as given)
- there are no costs or impediments to bargaining and the courts
will costlessly enforce any bargain the parties agree to
- agents do not engage in strategic behaviours that lead to a
breakdown in bargaining (no over reaching, emotional
complications etc.)
09/22/09
Prop_B
33
Problem
The above set of restrictions is rather severe
Many instances of pollution or private property disputes
involve situations in which one or more of the above
conditions does not hold
- initial allocation of property rights matters for
efficiency outcome
- trading is not likely to occur.
09/22/09
Prop_B
34
Evidence for and against Coase:
An enormous amount of private bargaining over property
rights goes on day-to-day
- much of this bargaining represents the
Coase theorem at work
- however, the interesting situations (the ones we hear
about most frequently) tend to be the situations in
which the ‘Coase theorem’ does not hold
- Later on we will see some of these ‘interesting’
situations
09/22/09
Prop_B
35
The normative Coase theorems
The law can actually help to lower transaction costs and
facilitate bargaining
- why not try to expand the set of situations in which
private bargaining will be successful
More formally - some transaction costs are ‘endogenous’ to
the legal system, in that the legal system can actually act
so as to lower transaction costs
Normative Coase Theorem: structure the law so as to
minimize private transaction costs
(it is a ‘normative’ statement in that is prescribes a social
criteria)
09/22/09
Prop_B
36
For example:
- establish clear and simple rules of ownership
such as ‘first in time, first in right’
- registration of land ownership
- registration of mortgages and liens
- registration of patents and copyright
- monitoring of odometer readings over the life of an
automobile
09/22/09
Prop_B
37
Normative Hobbes Theorem
The normative Hobbes theorem: structure the law so as to
minimize the risk, and resulting harm, of failures in private
agreements
The normative Hobbes Theorem implies that the law should
allocate property rights to the party that values them most.
For example, in our communications example, the law should
assign property rights to Local Cable Inc., thereby ensuring
that the least cost solution to the problem will result
without the need for private bargaining (But what about
the other city?)
09/22/09
Prop_B
38
Thomas Hobbes (17th century English philosopher) believed
that, that in general, individuals were not rational enough
to be able to agree on the division of the cooperative
surplus and that private bargaining would tend to break
down for this reason alone.
He believed that a stronger third party would be required to
enforce private agreements.
This leads to the notion that the law should acknowledge that
private parties will tend to resort to coercive threats or
destructive disagreement, and that bargaining will generally
fail.
09/22/09
Prop_B
39