II. Law and economic analysis
B. Foundations for the economic analysis of the common law
2. Coase and externalities
b. Externalities may not cause inefficiency (cont'd.)

    --In a Coase world, although we achieve an efficient outcome with any assignment of rights, we may not achieve the same outcome.
    --if a change of legal rule changes the distribution of wealth, output levels can change. (Regan, LEA 116-117)

Continue worksheet

    Result:
    A = Kelty's amount demanded to give up the right to be free of pollution
    B = Kelty's maximum willingness to pay to be get the right to be free of pollution

    C = control cost

    If A > C > B, then:
        Efficiency => no pollution if pollutee gets the property right
        Efficiency => pollution if polluter gets the property right

    Coase Theorem corollary: The particular efficient outcome we get can depend on how property rights are assigned

    So we can have different uses of resources according to who gets the right to impose costs--but both outcomes are efficient.
    A>B is a common result: all it requires is that environmental quality be a normal good.

    How your desires get weighted in determing the efficient outcome depends in part on how much money you have, and different initial allocations correspond to different distributions of wealth.

    "[I]n the ideal market setting law can pursue non-economic objectives without any sacrifice of economic efficiency." (Veljanovski, LEA 26)

    c. The real problem is transaction costs, not externalities

    What are transaction costs?
    Ttransaction costs: "the costs of effecting a transfer of rights" (P 34)
    Transaction costs: (1) search costs, (2) bargaining costs, (3) enforcement costs (CU 92)

    "The argument has proceeded up to this point on the assumption that there were no costs involved in carrying out market transactions. This is, of course, a very unrealistic assumption. In order to carry out a market transaction it is necessary to discover who it is that one wishes to deal with, to inform people that one wishes to deal and on what terms, to conduct negotiations leading up to a bargain, to draw up the contract, to undertake the inspection needed to make sure that the terms of the contract are being observed, and so on. These operations are often extremely costly, sufficiently costly at any rate to prevent many transactions that would be carried out in a world in which the pricing system worked without cost." (Coase 7)

    Additional transaction complications raised after Coase article:
    (1) strategic behavior
    "For participants in n-person, variable-sum games we do not...have any real satisfactory concept of rational behavior.... Each individual will wish to see not only that the benefits of cooperation are achieved, but that he gets as large a share of the benefits as possible. He will likely be led to threats of non-cooperation as a device to increase his share. Clearly the threats will be ineffective if they are not believed, and it is unlikely that threats will be generally be believed unless they are occasionally carried out." (Regan, LEA 115) Regan, Donald H. "The problem of social revisited." JLE 15 (1972): 427.)
    Friedman emphasizes this in chapter 5.

       (2) bilateral monopoly - 2-party bargaining situation -- monopoly facing a monopsony
    High potential stakes for each make each inclined to devote lots of resources to claim the surplus.

    Note:

    Example: sparks and crops (used by Pigou to illustrate logic of assessing damages)
    Irony to Coase: "The example used by Pigou refers to a real situation. In Britain, a railway does not normally have to compensate those who suffer damage by fire caused by sparks from an engine....
    "In the real world, Pigou's example could only exist as a result of a deliberate choice of the legislature.... The only circumstances in which compensation would not be paid would be those in which there had been government action. It is strange that Pigou, who clearly thought it desirable that compensation should be paid, should have chosen this particular example to demonstrate how it is possible 'for State action to improve upon `natural' tendencies.'" (Coase 13-14)

    Key lessons:
    (1) When transactions costs are zero, the Coase theorem applies and bargaining can work better than a Pigouvian solution.

    It won't matter for efficiency how property rights are assigned, the Nike rule applies: "just do it."

    Example of simple rules:
    "Polluter pays"
    "Deep pocket pays"

    (2) When transactions costs are nonzero, efficiency can depend on how rights are assigned

    With transactions costs, "the initial delimitation of legal rights does have an effect on the efficiency with which the economic system operates. One arrangement of rights may bring about a greater value of production than any other. But unless this is the arrangement of rights established by the legal system, the costs of reaching the same result by altering and combining rights through the market may be so great that this optimal arrangement of rights, and the greater value of production which it would bring, may never be achieved." (Coase 8)

    Return to Coase cases--Coase commentary handout
    (1) Sturges v. Bridgman (1879) - doctor v. confectioner
    What efficiency effect hinges on the court decision?
    "[T]he circumstances in which it would not pay the confectioner to continue to use the machinery and to compensate the doctor for the losses that this would bring (if the doctor had the right to prevent the confectioner's using his machinery) would be those in which it would be in the interest of the doctor to make a payment to the confectioner which would induce him to discontinue the use of the machinery (if the confectioner had the right to operate the machinery).... With costless market transactions, the decision of the courts concerning liability for damage would be without effect on the allocation of resources. It was of course the view of the judges that they were affecting the working of the economic system--and in a desirable direction."

    (2) Cooke v. Forbes (1867-8) - matting mfr v. chemical mfr
    Sturges v. Bridgman ruled for plaintiff; here for the defendant--what difference does it make?
    "[T]he situation is essentially the same as that found in Sturges v. Bridgman, except that the cocoa-nut fiber matting manufacturer could not secure an injunction...."

    (3) Bryant v. Lefever (1878-9) - chimney v. wall
    Who caused the smoke nuisance?
    "Who caused the smoke nuisance? The answer seems fairly clear. The smoke nuisance was caused both by the man who built the wall and by the man who lit the fires. Given the fires, there would have been no smoke nuisance without the wall; given the wall, there would have been no smoke nuisance without the fires. Eliminate the wall or the fires and the smoke nuisance would disappear. On the marginal principle it is clear that both were responsible and both should be forced to include the loss of amenity due to the smoke as a cost in deciding whether to continue the activity which gives rise to the smoke. And given the possibility of market transactions, this is what would in fact happen."

    (4) Bass v. Gregory (1890) - public (beer) house v. private house
   How relevant is the "doctrine of lost grant" to the economic problem presented by the case?
    "The economic problem was to decide which to choose: a lower cost of beer and worsened amenities in adjoining houses or a higher cost of beer and improved amenities. In deciding this question, the "doctrine of lost grant" is about as relevant as the colour of the judge's eyes. But it has to be remembered that the immediate question faced by the courts is not what shall be done by whom but who has the legal right to do what. It is always possible to modify by transactions on the market the initial legal delimitation of rights. And, of course, if such market transactions are costless, such a rearrangement of rights will always take place if it would lead to an increase in the value of production."

    Finish with overall Coase recap