Econ 522 – Lecture 4 (Sept 11 2008)
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 prevent certain trades that would have been beneficial; and second, any resources actually spent overcoming the transaction costs are, in a sense, 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. eBay
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. Famous paper by Akerloff, “The Market for Lemons,” dealing with this problem (adverse selection), showing that under some conditions, it can cause the market to fail completely.
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 holdout – individual sellers holding out for high prices – and freeriding – individual buyers trying to get the good for free. Either of these could 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. I’ll come back to this at the end of the lecture. 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:
- 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,
- 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, we’ll 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.