PROPERTY RIGHTS AND CONTRACTS October 10, 2006

PROPERTY RIGHTS AND CONTRACTS October 10, 2006 Coase Theorem Exceptions To Coase Theorem Transaction Costs - October 17, 2006 Asymmetric Information - October 24, 2006 Empty Core - October 31, 2006

CONTRACTS – Terms And Conditions October 10, 2006 COLOUR CODE FOR GRAPHS Marginal Cost Curve for Agent (firm, individual) under a strict liability rule Marginal Cost Curve for Agent (firm, individual) under a no liability rule Marginal Cost Curve for Agent (firm, individual) under a negotiated contract that follows the Theoem of Coase Demand Curve for the Agent’s output Marginal Revenue Curve

CONTRACTS – Terms And Conditions October 10, 2006 COLOUR CODE FOR GRAPHS (con’t) Average Cost Curve for Agent (firm, individual) with no transaction costs Average Cost Curve for Agent (firm, individual) with transaction costs Profit of Agent (firm, individual) Portion of profit traded in exchange for property rights Portion of profit lost due to a trade in property rights Portion of profit lost due to transaction costs

PROPERTY RIGHTS Contracting Property Rights Recall that in the McKie v. KVP case, Justice McRuer J. dismissed the “Crown lease” argument raised by KVP on the grounds that any contract permitting harm to the Plaintiffs' property must be done by way of an express contract among all the parties.

PROPERTY RIGHTS Contracting Property Rights In making this finding, McCruer was unintentionally raising a central point in the economic analysis of property rights – that it might be conceivably be possible that, for a payment, a party might agree by contract to allow another party to inflict harm on it.

PROPERTY RIGHTS Contracting Property Rights What kind of a contract was McRuer J. imagining here?

PROPERTY RIGHTS Contracting Property Rights Recall the “nuisance problem” discussed in the third lecture dated September 26, 2006?

PROPERTY RIGHTS Contracting Property Rights Agents operate two firms: a 1 = output of Agent 1 a 2 = output of Agent 2

PROPERTY RIGHTS Contracting Property Rights The profit function of Agent 1 is:  1 = pa 1 – C(a 1 ) The pollution function of Agent 1 is: D(a 1 ) = (a 1 )^ 2

PROPERTY RIGHTS Contracting Property Rights Perfectly Competitive-Agent 1 Market – Agent 1 S S D P a1a1 MCSATC

PROPERTY RIGHTS Contracting Property Rights Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S S = MC 1 D P a1a1 MC 1 SATC P PC PMPM LATC

PROPERTY RIGHTS Contracting Property Rights Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC

PROPERTY RIGHTS Contracting Property Rights Recall that the output of Agent 1 is jointly produced with pollution which imposes damages on Agent 2 according to the damage function D(a 1 ) = (a 1 )^ 2

PROPERTY RIGHTS Contracting Property Rights Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 1 P PC PMPMPMPM LATC No negative externality Negative externality

PROPERTY RIGHTS Strict Liability Rule. Agent 2 has theexclusive use to itsproperty rights Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

PROPERTY RIGHTS Strict Liability Rule Recall that Agent 2’s property rights include the right to sue Agent 1 Furthermore, if Agent 1 “knows” this, it will produce the socially optimal level of output and pollution

PROPERTY RIGHTS Strict Liability Rule The profit function of Agent 1 under the strict liability rule becomes:  1 = pa 1 – C(a 1 ) - (a 1 )^ 2  1 = 25/16

PROPERTY RIGHTS Strict Liability Rule Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC No Liability Strict Liability Rule

PROPERTY RIGHTS Strict Liability Rule So Agent 1 takes into account the ability of Agent 2 to sue it when it maximizes its profits: Output = (a 1 )* = 5/8 Pollution = (a 1 )^ 2 * = 25/64

PROPERTY RIGHTS Strict Liability Rule Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC Strict Liability Rule MC 1

PROPERTY RIGHTS Strict Liability Rule Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 2 P PC PMPM LATC Strict Liability Rule MC 2

PROPERTY RIGHTS No Liability Rule. Agent 2 loses theexclusive use to itsproperty rights toprotect it againstpollution Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

PROPERTY RIGHTS No Liability Rule The profit function of Agent 1 under the no liability rule becomes:  1 = pa 1 – C(a 1 )  1 = 25/12 > 25/16

PROPERTY RIGHTS No Liability Rule So Agent 1 does not take into account the possibility of Agent 2 to sue it when it maximizes its profits: Output = (a 1 )** = 5/6 > 5/8 Pollution = (a 1 )^ 2 ** = 25/36 > 25/64

PROPERTY RIGHTS No Liability Rule Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC No Liability MC 1

PROPERTY RIGHTS No Liability Rule Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 2 P PC P’ M P M LATC No Liability Rule MC 2

PROPERTY RIGHTS Contracting Property Rights NEGOTIATION

PROPERTY RIGHTS Collusion Could Agent 1 and Agent 2 collude to maximize social surplus, thereby increasing individual profits?

PROPERTY RIGHTS Collusion – No Liability Rule Applies. Agent 2 has lost theexclusive use to itsproperty rights toprotect it againstpollution Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

PROPERTY RIGHTS Collusion – No Liability Rule Applies Although Agent 1 can produce more and Agent 2 will produce less under the no liability law, Agent 1 might be persuaded to also produce less in exchange for a transfer payment that might allow Agent 2 to produce more

PROPERTY RIGHTS Collusion – No Liability Rule Applies The legal problem of nuisance now becomes a contract problem : Agent 2 wishes to make a payment to Agent 1 (a bribe) to induce Agent 1 to reduce its output from the market or private efficiency level of a P1 = 5/6. What bribe is Agent 2 willing to pay for a given level of output a C1 < a P1 = 5/6?

PROPERTY RIGHTS Collusion – No Liability Rule Applies Agent 1 sets its production at a new “contracted” level, which is still socially sub-optimal, but it takes into account both the payment and the pollution: MAX [pa 1 – C(a 1 ) + PAYMENT - D(a 1 )] = MAX [5a 1 – 3 a 1 ^ 2 + PAYMENT]

PROPERTY RIGHTS Collusion – No Liability Rule Applies Principal PAYMENT Agent PROMISED PERFORMANCE Agent PARTICIPATION CONSTRAINT INCENTIVE COMPATIBILITY CONSTRAINT LEGAL ANALYSIS PROMISED ECONOMIC ANALYSIS

PROPERTY RIGHTS Collusion – No Liability Rule Applies So the participation constraint for the bribe payment offered to Agent 1 by Agent 2:  C1 =  (a C1 ) + BRIBE > 25/12 Why? Because under no contract, Agent 1 can at the very least earn  1 = 25/12

PROPERTY RIGHTS Collusion – No Liability Rule Applies Damages suffered by Agent 2 without the payment to Agent 1 would be: D(a P1 ) = 25/36 Minimum damages suffered by Agent 2 under the strict liability “ideal” would be: D(a SO1 ) = 25/64

PROPERTY RIGHTS Collusion – No Liability Rule Applies Damages suffered by Agent 2 without the payment to Agent 1 would be: D(a P1 ) = 25/36 However, if the ideal of “zero-pollution” operates for Agent 2 : D(a O1 ) = 0 Maximum Payment From Agent 2 25/36

PROPERTY RIGHTS Collusion – No Liability Rule Applies Profit earned by Agent 1 without the payment to Agent 1 would be:  1 (a P1 ) = 25/12 Profit earned by Agent 1 under the strict liability “rule” would be:  1 (a SO1 ) = 25/16 Minimum Payment to Agent 1 25/48

PROPERTY RIGHTS Collusion – No Liability Rule Applies The “optimal” bribe or transfer payment lies within the interval: 25/48 < PAYMENT < 25/36 This interval is called the “core” of the contract, since any point in the interval would be a Nash equilibrium

PROPERTY RIGHTS Collusion – No Liability Rule Applies The incentive compatibility constraint for Agent 1 promising to cut back pollution:  (a P1 ) < p(a C1 ) + PAYMENT where a C1 is the “contracted” level of output

PROPERTY RIGHTS Collusion – No Liability Rule Applies The “core” of the contract represents the intersection set of feasible or possible contract points that satisfy (i) the participation constraint of the polluter (Agent 1) (ii) the incentive compatibility constraint of the polluter (Agent 2)

PROPERTY RIGHTS Collusion – No Liability Rule Applies Note that if it costs Agent 1 more than 25/36 in transaction costs to enter the contract with Agent 2, then the contract will not happen T < 25/36

PROPERTY RIGHTS Collusion – No Liability Rule Applies PRINCIPAL Agent 2 Offers a Bribe or a Transfer Payment To Agent 1 AGENT Agent 1 promises to cutback production or incur the expense of pollution abatement promise payment

PROPERTY RIGHTS Collusion – No Liability Rule Applies Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC No Liability MC 1

PROPERTY RIGHTS Collusion – No Liability Rule Applies Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 2 P PC P’ M P M LATC No Liability Rule MC 2

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies. Agent 2 has theexclusive use to itsproperty rights toprotect it againstpollution Agent 1 creates a harmful nuisance that hurts Agent 2 economically.

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies Although Agent 2 can produce more and Agent 1 will produce less under the strict liability rule, Agent 2 might be persuaded to also produce less in exchange for a transfer payment that might allow Agent 1 to produce more

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies The Legal problem of nuisance again becomes a Contract problem : Agent 1 wishes to make a payment to Agent 2 (a bribe) to induce Agent 2 to allow its output to be reduced from the legally protected level. What bribe is Agent 1 willing to pay for a given level of output a C1 > a SO1

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies Agent 2 wants minimal pollution, but it takes into account both the payment and the pollution: MAX [PAYMENT - D(a 1 )]

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies Principal PAYMENT Agent PROMISED PERFORMANCE Agent PARTICIPATION CONSTRAINT INCENTIVE COMPATIBILITY CONSTRAINT LEGAL ANALYSIS PROMISED ECONOMIC ANALYSIS

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies So the participation constraint for the bribe payment offered to Agent 2 by Agent 1: SS C2 = BRIBE – D(a) < 25/64 Why? Because under no contract, Agent 2 can at the very least rely on the socially optimal level of pollution

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies Damages suffered by Agent 2 without the payment to Agent 1 would be: D(a P1 ) = 25/64 However, if the ideal of “0-pollution” operates for Agent 2 : D(a O1 ) = 0 Minimum Payment To Agent 2 25/64

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies Profit earned by Agent 1 without the payment to Agent 1 would be:  1 (a SO1 ) = 25/16 Profit earned by Agent 1 under the free market would be:  1 (a P1 ) = 25/12 Maximum Payment from Agent 1 25/48

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies The “optimal” bribe or transfer payment lies within the “core”: 25/64 < PAYMENT < 25/48

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies The incentive compatibility constraint for Agent 2 promising to endure pollution, for example, waiving its legal right to sue agent 1, is: D(a C1 ) - PAYMENT < D(a SO1 ) where a C1 is the “contracted” level of output for Agent 1

PROPERTY RIGHTS Collusion – Strict Liability Rule Applies PRINCIPAL Agent 1 Offers a Bribe or a Transfer Payment To Agent 2 AGENT Agent 2 promises to endure the pollution in exchange for the payment which makes it better off promise payment

PROPERTY RIGHTS Strict Liability Rule Applies Perfectly Competitive-Agent 1 Monopoly Market – Agent 1 S D P a1a1 MC 1 P PC PMPM LATC Strict Liability Rule MC 1

PROPERTY RIGHTS Strict Liability Rule Perfectly Competitive-Agent 2 Monopoly Market – Agent 2 S D P a1a1 MC 2 P PC PMPM LATC Strict Liability Rule MC 2

PROPERTY RIGHTS Coase’s Theorem. COASE’S THEOREM

PROPERTY RIGHTS Coase’s Theorem NOTE 1: Agent 1 relies on the “market mechanism” throughout because it is more optimal for it to do so. Agent 2 relies on a “non-market mechanism”, namely the legal system, throughout because it is more optimal for it to do so.

PROPERTY RIGHTS Coase’s Theorem NOTE 2: Social surplus increases under the contract. At least one party cannot be worse off.

PROPERTY RIGHTS Coase’s Theorem NOTE 3: Social surplus is improved by the same amount irregardless of which Agent has the property rights.

PROPERTY RIGHTS Coase’s Theorem NOTE 4: The distribution of the “equally improved” surplus can vary depending on which agent has the property rights.

PROPERTY RIGHTS Coase’s Theorem NOTE 5: The improved in social surplus by the same amount irregardless of which agent has the property rights is reflected in the result that the “most efficient” use of the property occurs irregardless which agent has the property rights

PROPERTY RIGHTS Coase’s Theorem NOTE 6: The property rights must be transferable. In effect, when Agent 2 was allowing greater pollution by Agent 1 in exchange for a payment, Agent 2 was really “selling” part of his property rights for a price.

PROPERTY RIGHTS Coase’s Theorem NOTE 7: As well, Agent 1 was really “selling” part of its property rights for a price when it forgoes its right to pollute.

PROPERTY RIGHTS Coase’s Theorem NOTE 8: The results in Coase’s Theorem explain why property rights are exchangeable like goods.

PROPERTY RIGHTS Coase’s Theorem NOTE 9: What aspects of the house buying transaction discussed in the October 3, 2006 lecture could be regarded as identical to the pollution contract?

PROPERTY RIGHTS Coase’s Theorem Incompatible Uses Sturges v. Bridgman

PROPERTY RIGHTS Coase’s Theorem Ronald Coase based his argument on an actual English common law nuisance case. Sturges v. Bridgman, (1879) 11 Ch. D. 852.

PROPERTY RIGHTS Coase’s Theorem In Sturges v. Bridgman, a doctor moved his medical practice into a building shared by a confectioner with a common landlord. The confectioner's noisy mortars prevented the doctor from examining his patients in his consulting room.

PROPERTY RIGHTS Coasean Contract The court ignored the terms in the tenants’ leases stipulating “quiet enjoyment” of their premises. The court found no liability for damages against the confectioner.

PROPERTY RIGHTS Coase’s Theorem By awarding no damages against the confectionary, the court is “harming” the doctor. Which harm is the least harmful? Which is the more efficient of the “incompatible” uses?

PROPERTY RIGHTS Railways vs. Farmers Railways Most Efficient Use

PROPERTY RIGHTS: COASE THEOREM Railways vs. Farmers At common law, farmers had a legal right to prevent the destruction of their crops by sparks from passing railroad locomotives. Coase, p. 30 Vaughan v. Taff Vale Railway Company, (1858) 3 L. R. Ex. Div. 743 (Ex. Ct.)

PROPERTY RIGHTS Railways vs. Farmers In Vaughan v. Taff Vale Railway Company, Justice Bramwell ruled that railways should be liable for damages in trespass caused to farmers' fields from locomotive sparks.

PROPERTY RIGHTS Railways vs. Farmers On appeal, the House of Lords judicial committee granted an exception to the strict liability rule where statutes permitted use of certain types of locomotives. The lords ruled that these statutes gave the railways implicit immunity against farmers' nuisance actions. Posner, p. 39.

PROPERTY RIGHTS Railways vs. Farmers As well, railways could purchase easements or “right of ways” from adjoining farms in order to emit sparks from steam engines without legal liability. Mississauga Train Wreck

PROPERTY RIGHTS Railways vs. Farmers Such rights of way were leased to factories or other “compatible uses” by the railways. Former Irwin Toy factory - Toronto

PROPERTY RIGHTS Railways vs. Farmers Over time – Efficiency of Use changes Coase’s Theorem predicts these changes

PROPERTY RIGHTS Railways vs. Farmers

PROPERTY RIGHTS Defection DEFECTION

PROPERTY RIGHTS Defection If there were a Pareto superior position, would it be stable? If not, what would the pattern of defection be?

PROPERTY RIGHTS Defection Prisoners dilemna works against a collusive duopoly Prisoners dilemna could be “solved” in a collusive externality agency? P.O.E N.E P.O.E and N. E

PROPERTY RIGHTS Defection Cournot Defection Agents 1 and 2 enter into a collusive contract Each has an equal incentive to defect by increasing production The “defection game” is a “sequential game” Property and Defection Each Agent does not have an incentive to defect

PROPERTY RIGHTS Defection Cournot Defection  Agent 1 decides to “defect” from the agreed upon quota: a 1 = (3/8)(1 - c) » Increased Profits of Agent 1 exceed its share of the collusive profits (3/16)(1 - c)(1 + c) > (1/8)(1 - c) ^2 Property and Defection

PROPERTY RIGHTS Defection Cournot Defection Production is scaled back to: » a 1 = a 2 = (1/3)(1 - c) Profits for both ultimately fall:  p 1 =p 2 =(1/9)(1- c) ^2 This is an example of rent dissipation Property and Defection High transaction costs Asymmetric information Too many parties These factors separate Nash equilibrium from Pareto optima

PROPERTY RIGHTS Defection Cournot Duopoly Negative Externality Axes a2a2 E Iso-Profit Curve For Agent 1 Iso-Profit Curve For Agent 2

PROPERTY RIGHTS Defection Prisoners dilemna works against a collusive duopoly Prisoners dilemna could be “solved” in a collusive externality agency? Yes. P.O.E N.E P.O.E and N. E

PROPERTY RIGHTS Prisoners dilemna works against a collusive duopoly P.O.E N.E However, prisoners dilemna works against negative externalities under the exceptions to the Theorem of Coase N.E P.O.E

PROPERTY RIGHTS Ranchers vs. Farmers Ranchers - Farmers Double Externalities

PROPERTY RIGHTS: COASE THEOREM Farmer - Rancher The rancher and the farmer also involve a "double" externality. The "double externality" emerges in the rancher – farmer problem because when the cattle eat the grain, not only does the farmer lose his crop, but the rancher gains better fed cattle.

PROPERTY RIGHTS: COASE THEOREM Farmer - Rancher Grain The farmer produces “y” amounts of wheat The rancher produces “x” amounts of cattle The “arrows” show the direction of profit increase for each party Nash Equilibrium [a, b] Cattle

PROPERTY RIGHTS: COASE THEOREM Farmer - Rancher Grain The iso-profit curve of the rancher is concave upwards, because as more cattle are raised, more of the farmer’s food is eaten Nash Equilibrium [a, b] Cattle

PROPERTY RIGHTS: COASE THEOREM Farmer - Rancher Grain The “shaded lens” reflects how the parties can increase joint profits by co- operative behaviour Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain The traditional “common law” remedy for nuisance is a “property rule” that favours the farmer The common law rule increases “surplus” to the farmer at the “expense” of rancher More grain is produced Fewer cattle are produced Common Law Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain Bargaining in the “lens” that maximizes joint surplus will allow both parties to gain Profits increase substantially for the rancher at the expense of the farmer However, the rancher might make a payment to the farmer for permission to breed more cattle Common Law Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain The payment allows net profits to increase “marginally” for the farmer beyond the “common law” equilibrium More cattle – less grain Transaction costs = 0 Coase, pp. 4, 6 Common Law Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain So under the traditional common law rule that awards damages against the rancher for his roving cattle, it will pay the rancher to offer part of its surplus to the farmer In bargaining, the parties have “altered” the “common law rule” imposed on them by adapting their own “contract rule” to the contract New Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain If the traditional “common law” remedy for nuisance is replaced with a “no damages” rule The “no damages” rule increases “surplus” to the rancher at the “expense” of farmer Less grain is produced More cattle are produced No Damages Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain Bargaining in the “lens” that maximizes joint surplus will allow both parties to gain Profits increase substantially for the farmer at the expense of the rancher However, the farmer will make a payment to the rancher for an incentive to breed less cattle No Damages Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain The payment allows net profits to increase “marginally” for the rancher beyond the “common law” equilibrium Fewer cattle – more grain Transaction costs = 0 Coase, pp. 6-8 No Damages Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain So under the “no damages” rule that awards no damages against the rancher for his roving cattle, it will pay the farmer to offer part of its surplus to the rancher In bargaining, the parties have “altered” the “no damages rule” imposed on them by adapting their own “contract rule” to the contract New Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Direction Of Payment Grain Bargaining in the “lens” that maximizes joint surplus will allow both parties to gain Profits increase substantially for the farmer at the expense of the rancher However, the farmer will make a payment to the rancher for an incentive to breed less cattle No Damages Nash Equilibrium Cattle

PROPERTY RIGHTS: COASE THEOREM Applications Other Applications Planned Economies – Where incompatible uses are managed by the same organization »Merger of polluting agent with victim Local Economies – Where an assessment from primary employer used to subsidize the victims »Shopping Mall downwind from a polluting agent