G601 History of Thought, policy , 27 September 2006 Coase Theorem-Friedman, Harberger- -Stigler Eric Rasmusen, erasmuse@Indiana.edu

Readings Classics: Public Policy     George J. Stigler (1971) "The Theory of Economic Regulation" The Bell Journal of Economics and Management Science, 2(1): 3-21 (Spring 1971)     David Friedman, Law's Order, chapters 4 and 5, pages 36-62, on the Coase Theorem and Calabresi and Melamed. (See http://www.daviddfriedman.com/laws_order. )     Arnold C. Harberger (1954) "Monopoly and Resource Allocation," The American Economic Review, Papers and Proceedings of the Sixty-sixth Annual Meeting of the American Economic Association, 44(2): 77-87 (May 1954) This seems a miscellany of articles. Ihey are all law-adn-economics, though. Three big ideas: Antitrust Law Regulation-political Economy Coase Theorem—transaction costs

Handouts Your problem sets problem set answers

Big Ideas in Law-and-Economics 1. Harberger Triangles: losses from market-power allocative distortions are small, empirically. 2. Regulation is by Regulators: it serves the interests of individuals, not of a social planner. 3. The Coase Theorem and Rights: If bargaining costs are low, people will bargain to an efficient outcome, but otherwise the initial allocation of rights matters to efficiency.

    Arnold C. Harberger (1954) "Monopoly and Resource Allocation," The American Economic Review, Papers and Proceedings of the Sixty-sixth Annual Meeting of the American Economic Association, 44(2): 77-87 (May 1954)

Harberger’s Method 1. Get return on capital in mfgr. industries, and sales (q) 2. Calculate deviations from average profit as a percentage of sales. Call this r. 3. Assume the elasticity of demand, k, for each industry equals 1. 3. Calculate .5 r^2qk for each industry. 4. Add them up. 5. Multiply 2.2 since we just looked at a fraction of manuf. industries. 5. The result: about .1% of national income.

Harberger’s Refinements 1. What if there are increasing costs in industries? 2. Equity capital is measured to include the value of patents, which capitalizes monopoly profits. So it is greater than the amount of real capital supplied, and monopoly profits might look too low. 3. Sample selection bias. These industries have an average profit of 10.4%, while for manufaturign as a whole it was 8%. 4. Aggregation. This smooths out differences in profit rates across products.

Some Big Problems 1. Why include the low-profit industries? 2. Why use return on capital instead of return on equity? Bondholders do not get monopoly profit. 3. What if all industries are monopolized, and profit rates are all equal? His method would show zero loss. 4. What about labor monopolies? (unions, restrictive entry of the kind Stigler discusses)

Another Approach Suppose ALL of the return to equity is monopoly profit. What is the welfare loss? US Mfgr corporations had profit of 245 billion dollars in 1998. Sales were 4,591 billion. So the profit rate on sales was .053. And the triangle loss was .5 (.053)(.053) (4591) = 6.5 billion dollars. GDP was 8790 billion dollars, so the loss is .07% of GDP.

Refinement: Fewer monopoly industries Suppose ALL of the return to equity is monopoly profit. What is the welfare loss? US Mfgr corporations had profit of 245 billion dollars in 1998. Sales were 4,591 billion. So the profit rate on sales was .053. Suppose a quarter of firms are monopolies, with profits of 20%, and 3/4 are not, with profits of 0% of sales. Then the triangle loss is .5 (.20)(.20) (.25) (4591) = 23.0 billion dollars. What if prices were double what they should be, in every industry? Then the approximation involved gets bad, but we can compute . 5(1) (1) 4591 = 2296, and the loss is 26% of GDP.

Big Ideas in Law-and-Economics 1. Harberger Triangles: losses from market-power allocative distortions are small, empirically. 2. Regulation is by Regulators: it serves the interests of individuals, not of a social planner. 3. The Coase Theorem and Rights: If bargaining costs are low, people will bargain to an efficient outcome, but otherwise the initial allocation of rights matters to efficiency.

George J. Stigler (1971) "The Theory of Economic Regulation" The Bell Journal of Economics and Management Science, 2(1): 3-21 (Spring 1971)    

Stigler: What does Government Supply? Answer: The power to coerce. Violence. 1. Direct subsidy (US airlines before 1968, universities) 2. Entry restrictions (US airlines before 1975, tariffs) 3. Suppression of substitute goods (margarine, plastic pipes) 4. Price-fixing (interest rate regulation, advertising restrictions)

Big Ideas in Law-and-Economics 1. Harberger Triangles: losses from market-power allocative distortions are small, empirically. 2. Regulation is by Regulators: it serves the interests of individuals, not of a social planner. 3. The Coase Theorem and Rights: If bargaining costs are low, people will bargain to an efficient outcome, but otherwise the initial allocation of rights matters to efficiency.

Coase, Ronald.The Problem of Social Cost, 3 Journal of Law and Economics 1-44 (1960) Calabresi, Guido and Melamed, A. Douglas (1972), Property Rules, Liability Rules and Inalienability: One View of the Cathedral , 85 Harvard Law Review, 1089-1128.

Coase Theorem Example A steel mill’s pollution reduces resort profit by $200,000 unless $100,000 is paid to control pollution. There is a real externality of $200,000. The Pigouvian tax would be to charge the steel mill $200,000 if it pollutes. It would then choose to control the pollution instead. Coase insight: Suppose the resort could switch to timber, earning $50,000 less. Then the Pigouvian tax is inefficient. Or, just let the steel mill and the resort negotiate with each other. If the “property right”– who has the legal right to decide pollution– is clear, the outcome will be efficient.

The Coase Theorem “If transaction costs are zero, then any initial allocation of property rights leads to an efficient outcome. “ (Friedman’s statement) What is interesting is to figure out the implications of transaction costs. A function of law is to minimize transaction costs. http://www.daviddfriedman.com/laws_order/

Property and Liability Rules If you are protected by a property rule, you can go to court and get an injunction to stop someone from doing X. (court of common law). Good if transactions are cheap. Examples: Patent infringement, someone building a house on your land, someone stealing your car. If you are protected by a liability rule, you can go to court and get damages from someone who has done X. (court of equity) Good if courts are cheap. Examples: tort suits for personal injury, damages for breach of contract Calabresi, Guido & Melamed, Douglas, "Property Rules, Liability Rules and Inalienability: One View of the Cathedral", 85 Harvard Law Review 1089 (1972).

The Train Sparks Example A railroad chooses whether to install a spark arrester at cost $1000 or not. 100 farmers each choose whether to plant clover or wheat. Clover does not burn, but yields $800 less in revenue. Wheat burns, for a loss of $400. Possible Rules (who decides? who pays?): 1. Railroad property right. The railroad can throw sparks if it so desires. 2. Farmer property right. Any one farmer can stop the railroad from throwing sparks. 3. Farmer liability right. The railroad can throw sparks if it pays the farmers for any damage that results. 4. Railroad liability right. Any one farmer can stop the railroad from throwing sparks, but he must pay the railroad’s cost of installing a spark arrester.

Train Sparks II Possible Rules (no contracts enforced) A railroad chooses whether to install a spark arrester at cost $1000 or not. 100 farmers each choose whether to plant clover or wheat. Clover does not burn, but yields $800 less in revenue. Wheat burns, for a loss of $400. Possible Rules (no contracts enforced) Railroad property right. Farmers plant wheat and it burns. $400 cost. 2. Farmer property right. RR installs spark arrester. $1,000 cost. 3. Farmer liability right. Farmers plant wheat and it burns. $400 cost. The RR pays $400 to the farmer. 4. Railroad liability right. Farmers plant wheat and it burns. $400 cost. (The farmers could insist on the spark arrester, but they’d have to pay the $1,000.)

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