1 Agenda for 13th Class Efficiency Coase Theorem Assignment for Next Class –##59-60 –Questions to think about / Writing Assignment for Group 1 Pp. 240ff Qs 1-6

2 Convenants Not To Compete When A sells business to B, sale often contains “covenant not to compete” which forbids A from starting competing business for fixed period of time –Mentioned in National Society –Can be beneficial, because facilitates sale, and thus encourages A’s initial investment in the business When A works for B, employment contract sometimes forbids A from taking job at competing firm after employment terminates –Can be beneficial, if prevents A from divulging trade secrets to B’s competition and thus encourages B to share trade secrets –Always forbidden in California –Allowed in other states, if “reasonable” time and place limitations Conditions not to Compete –Employment contract between A and firm B which states that, if A does not work for a competing firm after termination of employment, B will pay A a certain amount of money –Same goal and benefits as covenants not to compete, but “carrot” instead of “stick” –Much less common –California law unclear. Employee protection v competition

3 Efficiency I Efficiency –Pareto. Situation is Pareto superior if it makes at least one person better off and no one worse off Situation is Pareto optimal or efficient, if there is no situation which is Pareto superior to it Problems –Very few legal changes make no one worse off –Ignores distribution »Situation in which I have all the wealth is efficient

4 Efficiency II Kaldor-Hicks Efficiency –Situation is Kaldor-Hicks superior if winners can compensate losers and still be better off Situation is Kaldor Hicks optimal or efficient, if there is no situation which is Kaldor-Hicks superior to it Roughly equivalent to cost-benefit analysis, where costs & benefits judged by willingness to pay Problems. Willingness to pay is not always ethically attractive criterion Wealth-maximization –Posner calls use of Kaldor-Hicks efficiency to choose among legal rules “wealth maximization” –Confusing, because “wealth” usually refers to things like stock, bonds, jewels, and real estate But selling stock to go on vacation can be “wealth maximizing,” if person values vacation more than stock

5 B’s well-being A’s well-being A B C D

6 Competitive Markets and Efficiency In general –Competitive markets are Pareto efficient Kaldor-Hicks efficient Maximize sum of producer and consumer surplus –Where surplus is measured »For producers as difference between cost and price »For consumers as difference between subjective benefit and price –Any deviation from competitive price Harms someone (so not Pareto superior) Blocks mutually beneficial transaction –Artificially low price blocks transaction between higher cost seller and high value buyer Analysis assumes –No externalities –Perfect information –No transactions costs –Benefits measured by willingness to pay

7 Coase Theorem Weak version: If there are no transactions costs, resources will be allocated efficiently regardless of the legal rule. Strong version. If there are no transactions costs, resources will be allocated efficiently and the same, regardless of the legal rule –Different from weak version, because there may be several ways to allocate resources efficiently. The strong version asserts that the same efficient allocation will be reached, regardless of initial assignment of rights –The strong version is correct only if there are no “wealth effects” (see below)

8 Transactions Costs Costs of negotiating agreements –Time of parties, cost of lawyers, cost of paper, etc. Cost of enforcing agreements –Time of parties, cost of lawyers, cost of paper, etc. Informational problems –Cost of acquiring necessary information –Adverse selection (which is a result of the costly nature of acquiring information about insureds) –Moral hazard (will discuss in future class) –Principal-agent problem (will discuss in future class) Legal prohibitions –Law forbidding contracting about rights e.g. selling kidneys, contracting out of product liability In general, transactions costs are high when –When large numbers of people are involved –When communication is difficult

9 Legal Rule Sometimes phrased as “regardless of assignment of rights” –Same idea Legal rules assign rights –Product liability law assigns right to damages to consumer Privity of contract doctrine denied such a right –Duty to rescue assigns right to damages to persons who could have been saved by passerby Common law granted no such right –Contract law generally assigns right to collect damages (but not injunctions) –Common law generally gave polluters the right to pollute Environmental regulations take away that right, but don’t allow polluters and others to negotiate

10 Efficiency Because of assumption of zero transactions costs, “efficiency” in Coase Theorem means both Pareto and Kaldor-Hicks efficiency –When transactions costs are zero, all Kaldor-Hicks efficient moves can be converted into Pareto efficient moves by paying compensation Because, with zero transactions costs, there is no impediment to paying such compensation

11 Same Allocation (strong version) Behavior is same –But parties may be better or worse off Pollution example –Same level of pollution will be emitted, whether laws exist to regulate pollution or now But polluters better off if no regulation; others better off if pollution regulated Injunction versus damages –Breach will occur just as often, whether legal remedy is damages or injunction But non-breaching party better off with right to injunction

12 Ancient Lights Consider two possible legal rules –Owner of building has right to enjoin construction which would block light (“ancient lights”) –Owner of building has no such right (American rule) Suppose legal rule is “ancient lights” –Owner’s valuation of light: $10,000 –Suppose builder gets $20,000 profit from constructing new building which would block light to owner –What will happen? Suppose legal rule is American rule –What will happen? Suppose Owner valuation of light is $40,000 –What will happen under the two legal rules?

13 Wealth Effects Example assumed owner’s valuation of light=$10,000 or $40,000 What mean? –How much willing to pay (WTP) to purchase right (if initially allocated to builder, e.g. American rule) –How much willing to accept (WTA) to waive right (if initially allocated to owner, e.g. Ancient Lights) Example assumes that WTP and WTA are the same –Not always true –Poor owner might not be willing to pay a lot to protect light, but might be willing to accept only a much larger sum to waive right –In general, the more valuable the right in relation to party’s wealth, the greater the divergence between WTP and WTA Large divergence – right to medicine, right to bodily integrity, right to food if starving, etc Duty to rescue. Poor parent might be willing to pay relatively little to rescue child, but might still demand very high amount to allow child to drown. (See next slide)

14 Wealth Effects & Duty to Rescue Poor child is stuck at bottom in bottom of well Poor parent loves child, but doesn’t have much money to pay others to rescue –WTP $1000. Would only pay $1000 to rescue child from mortal danger –WTA infinite. No amount of money would cause parent to allow child to die, if child would be saved Rescue costs $2000 to sole potential rescuer If law is “no duty to rescue,” child will die –Rescuer will have no legal duty to rescue –Parent will not be able to induce rescuer to rescue with money –Pareto efficient. Rescue would make at least rescuer worse off –Kaldor-Hicks efficient. Parent could not compensate rescuer for rescue If law is “duty to rescue” –Rescuer will have legal duty to rescue –Rescuer will not be able to pay parent for release from duty –Pareto efficient. Non-rescue would make parent worse off –Kaldor-Hicks efficient: Rescuer could not compensate parent for non- rescue

15 Point of Coase Theorem Simplistic interpretation –Law doesn’t matter Sophisticated interpretation –Need to focus on and understand transactions costs –In general, good to lower transactions costs Improve communication Remove legal barriers to negotiation Solve information problems –If transactions costs are (or can be made) low, then best to let market take course Legal allocation not that important –If transactions costs are (by necessity) high, then law is necessary Initial allocation of rights makes a big difference Law can make world much better place In real world, there are always transactions costs –If transactions costs are low, assumption of zero transactions costs can be helpful

16 Coase Theorem and Legal Rules Coase Theorem helps figure out what legal rule should be How depends on context Ancient Lights –If profit to new building usually higher than prior owner’s valuation of light Then, if transactions costs are zero new building will be built, regardless of legal rule BUT if transactions costs are positive and moderate, ancient lights rule will require costly negotiation –If transactions costs are very high, then ancient lights rule will block efficient allocation So American rule more efficient –Converse if prior owner’s valuation of light is higher than profit to new building

17 Coase Theorem and Legal Rules II Pollution –If transactions costs are zero, pollution controlled optimally, no matter the legal rule –Transactions costs are, in fact, very high, b/c too many people affected So rule which allocated right to pollute to potential polluters would result in an efficiently high amount of pollution –Some form of pollution regulation is probably efficient Of course, most efficient form of pollution control subject to debate

18 Externalities & Coase Theorem When externalities affect small number of people who can negotiate ex ante or who deal with each other repeatedly, probably don’t need law to correct or encourage –Nice or mean things done to family or friends –Contracts usually deal explicitly with externalities E.g. promisee pays for positive externality granted by promisor Parties indemnify each other for harm But law sometimes imposes mandatory terms –E.g. Product liability, medical malpractice liability –Covenants running with land, homeowners associations Deal with externalities among neighbors But when externalities affect large numbers of people, need law –Pollution, congestion, torts among strangers, etc.

19 Prisoners’ Dilemma Suspect 2 ConfessKeep quiet Suspect 1Confess-5, -5-1, -7 Keep Quiet-7, Dominant Strategy. Nash Equilibrium Each suspect imposes negative externalities on the other Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

20 Pollution Externalities Game Firm 2 PolluteInstall Firm 1Pollute-4000, , Install-5000, Almost identical to Prisoners’ dilemma If numbers small, might expect agreement to install pollution control When numbers large, negotiation very difficult –Collective action problem Everyone better off if everyone installs pollution control equipment But each person better off if free rides –Better to not install pollution control equipment, if everyone else does

21 Collective Action Problems Collective Action Problems are ubiquitous –Becoming informed voter, voting –Funding public goods, e.g. fire departments, bridges, national defense –Global warming –Fishing Every collective action problem is also an externalities problem –Sometimes groups can resolve Political lobbying by interest groups Democracy Voluntary organizations Clubs –Often government is only or best solution