PROPERTY RIGHTS AND CONTRACTS

1
PROPERTY RIGHTS AND CONTRACTS October 10, 2006
2
PROPERTY RIGHTS AND CONTRACTSOctober 10, 2006

• Coase Theorem
• Exceptions To Coase Theorem
• Transaction Costs - October 17, 2006
• Asymmetric Information - October 24, 2006
• Empty Core - October 31, 2006

3
CONTRACTS Terms And ConditionsOctober 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 Agents output
• Marginal Revenue Curve

4
CONTRACTS Terms And ConditionsOctober 10, 2006

• COLOUR CODE FOR GRAPHS (cont)
• 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

5
PROPERTY RIGHTSContracting 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.

6
PROPERTY RIGHTSContracting 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.
7
PROPERTY RIGHTSContracting Property Rights
What kind of a contract was McRuer J. imagining
here?
8
PROPERTY RIGHTSContracting Property Rights
Recall the nuisance problem discussed in the
third lecture dated September 26, 2006?
9
PROPERTY RIGHTSContracting Property Rights

• Agents operate two firms
• a1 output of Agent 1
• a2 output of Agent 2

10
PROPERTY RIGHTSContracting Property Rights

• The profit function of Agent 1 is
• p1 pa1 C(a1)
• The pollution function of Agent 1 is
• D(a1) (a1)2

11
PROPERTY RIGHTSContracting Property Rights

• Perfectly Competitive-Agent 1

• Market Agent 1

P
D
S
S
MC
SATC
a1
12
PROPERTY RIGHTSContracting Property Rights

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

P
D
S MC1
LATC
S
LATC
MC1
SATC
SATC
PM
PPC
a1
13
PROPERTY RIGHTSContracting Property Rights

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

P
D
LATC
S
LATC
MC1
PM
PPC
a1
14
PROPERTY RIGHTSContracting 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(a1)
(a1)2
15
PROPERTY RIGHTSContracting Property Rights

• Perfectly Competitive-Agent 2

• Monopoly Market Agent 2

P
No negative externality
D
LATC
S
LATC
MC1
PM PM
PPC
Negative externality
a1
16
PROPERTY RIGHTSStrict Liability Rule
Agent 1 creates a harmful nuisance that hurts
Agent 2 economically.
.
Agent 2 has the exclusive use to its property
rights
17
PROPERTY RIGHTS Strict Liability Rule

• Recall that Agent 2s 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

18
PROPERTY RIGHTS Strict Liability Rule

• The profit function of Agent 1 under the strict
  liability rule becomes
• p1 pa1 C(a1) - (a1)2
• p1 25/16

19
PROPERTY RIGHTS Strict Liability Rule

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

No Liability
P
D
LATC
S
LATC
MC1
PM
PPC
Strict Liability Rule
a1
20
PROPERTY RIGHTSStrict Liability Rule

• So Agent 1 takes into account the ability of
  Agent 2 to sue it when it maximizes its profits
• Output (a1) 5/8
• Pollution (a1)2 25/64

21
PROPERTY RIGHTS Strict Liability Rule

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

P
D
LATC
S
LATC
MC1
MC1
PM
PPC
Strict Liability Rule
a1
22
PROPERTY RIGHTS Strict Liability Rule

• Perfectly Competitive-Agent 2

• Monopoly Market Agent 2

P
Strict Liability Rule
D
LATC
S
LATC
MC2
MC2
PM
PPC
a1
23
PROPERTY RIGHTSNo Liability Rule
Agent 1 creates a harmful nuisance that hurts
Agent 2 economically.
.
Agent 2 loses the exclusive use to its property
rights to protect it against pollution
24
PROPERTY RIGHTS No Liability Rule

• The profit function of Agent 1 under the no
  liability rule becomes
• p1 pa1 C(a1)
• p1 25/12 gt 25/16

25
PROPERTY RIGHTSNo Liability Rule

• So Agent 1 does not take into account the
  possibility of Agent 2 to sue it when it
  maximizes its profits
• Output (a1) 5/6 gt 5/8
• Pollution (a1)2 25/36 gt 25/64

26
PROPERTY RIGHTS No Liability Rule

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

No Liability
P
D
LATC
S
LATC
MC1
MC1
PM
PPC
a1
27
PROPERTY RIGHTS No Liability Rule

• Perfectly Competitive-Agent 2

• Monopoly Market Agent 2

P
D
LATC
MC2
S
LATC
MC2
PM PM
PPC
No Liability Rule
a1
28
PROPERTY RIGHTS Contracting Property Rights
29
PROPERTY RIGHTS Collusion

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

30
PROPERTY RIGHTS Collusion No Liability Rule
Applies
Agent 1 creates a harmful nuisance that hurts
Agent 2 economically.
.
Agent 2 has lost the exclusive use to its
property rights to protect it against pollution
31
PROPERTY RIGHTSCollusion 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

32
PROPERTY RIGHTSCollusion 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 aP1 5/6. What bribe is
Agent 2 willing to pay for a given level of
output aC1 lt aP1 5/6?
33
PROPERTY RIGHTSCollusion 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 pa1 C(a1) PAYMENT - D(a1)
MAX 5a1 3a12 PAYMENT
34
PROPERTY RIGHTS Collusion No Liability
Rule Applies
LEGAL ANALYSIS PROMISED
ECONOMIC ANALYSIS
Principal PAYMENT
Agent PARTICIPATION CONSTRAINT
Agent PROMISED PERFORMANCE
INCENTIVE COMPATIBILITY CONSTRAINT
35
PROPERTY RIGHTS Collusion No Liability Rule
Applies
So the participation constraint for the bribe
payment offered to Agent 1 by Agent 2 pC1
p(aC1) BRIBE gt 25/12 Why? Because under no
contract, Agent 1 can at the very least earn p1
25/12
36
PROPERTY RIGHTS Collusion No Liability Rule
Applies
Damages suffered by Agent 2 without the
payment to Agent 1 would be D(aP1)
25/36 Minimum damages suffered by Agent 2
under the strict liability ideal would
be D(aSO1) 25/64
37
PROPERTY RIGHTS Collusion No Liability Rule
Applies
Damages suffered by Agent 2 without the
payment to Agent 1 would be D(aP1)
25/36 However, if the ideal of
zero-pollution operates for Agent 2 D(aO1)
0 Maximum Payment From Agent
2 25/36
38
PROPERTY RIGHTS Collusion No Liability Rule
Applies
Profit earned by Agent 1 without the payment
to Agent 1 would be p1 (aP1)
25/12 Profit earned by Agent 1 under the
strict liability rule would be p1(aSO1)
25/16 Minimum Payment to Agent 1 25/48
39
PROPERTY RIGHTSCollusion No Liability Rule
Applies

• The optimal bribe or transfer payment lies
  within the interval
• 25/48 lt PAYMENT lt 25/36
• This interval is called the core of the
  contract, since any point in the interval would
  be a Nash equilibrium

40
PROPERTY RIGHTSCollusion No Liability Rule
Applies
The incentive compatibility constraint for Agent
1 promising to cut back pollution p(aP1) lt
p(aC1) PAYMENT where aC1 is the contracted
level of output
41
PROPERTY RIGHTSCollusion 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)
42
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 lt 25/36
43
PROPERTY RIGHTS Collusion No Liability
Rule Applies
PRINCIPAL Agent 2 Offers a Bribe or a Transfer
Payment To Agent 1
promise
payment
AGENT Agent 1 promises to cutback production
or incur the expense of pollution abatement
44
PROPERTY RIGHTSCollusion No Liability Rule
Applies

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

No Liability
P
D
LATC
S
LATC
MC1
MC1
PM
PPC
a1
45
PROPERTY RIGHTSCollusion No Liability Rule
Applies

• Perfectly Competitive-Agent 2

• Monopoly Market Agent 2

P
D
LATC
MC2
S
LATC
MC2
PM PM
PPC
No Liability Rule
a1
46
PROPERTY RIGHTSCollusion Strict Liability Rule
Applies
Agent 1 creates a harmful nuisance that hurts
Agent 2 economically.
.
Agent 2 has the exclusive use to its property
rights to protect it against pollution
47
PROPERTY RIGHTSCollusion 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

48
PROPERTY RIGHTSCollusion 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 aC1 gt aSO1
49
PROPERTY RIGHTSCollusion Strict Liability Rule
Applies
Agent 2 wants minimal pollution, but it takes
into account both the payment and the
pollution MAX PAYMENT - D(a1)
50
PROPERTY RIGHTS Collusion Strict
Liability Rule Applies
LEGAL ANALYSIS PROMISED
ECONOMIC ANALYSIS
Principal PAYMENT
Agent PARTICIPATION CONSTRAINT
Agent PROMISED PERFORMANCE
INCENTIVE COMPATIBILITY CONSTRAINT
51
PROPERTY RIGHTS Collusion Strict Liability
Rule Applies
So the participation constraint for the bribe
payment offered to Agent 2 by Agent 1 SSC2
BRIBE D(a) lt 25/64 Why? Because under no
contract, Agent 2 can at the very least rely on
the socially optimal level of pollution
52
PROPERTY RIGHTS Collusion Strict Liability
Rule Applies
Damages suffered by Agent 2 without the
payment to Agent 1 would be D(aP1)
25/64 However, if the ideal of
0-pollution operates for Agent 2 D(aO1)
0 Minimum Payment To Agent
2 25/64
53
PROPERTY RIGHTS Collusion Strict Liability
Rule Applies
Profit earned by Agent 1 without the payment
to Agent 1 would be p1 (aSO1)
25/16 Profit earned by Agent 1 under the
free market would be p1(aP1)
25/12 Maximum Payment from Agent 1 25/48
54
PROPERTY RIGHTSCollusion Strict Liability Rule
Applies
The optimal bribe or transfer payment lies
within the core 25/64 lt PAYMENT lt 25/48
55
PROPERTY RIGHTSCollusion 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(aC1) - PAYMENT lt D(aSO1) where aC1
is the contracted level of output for Agent 1
56
PROPERTY RIGHTS Collusion Strict
Liability Rule Applies
PRINCIPAL Agent 1 Offers a Bribe or a Transfer
Payment To Agent 2
promise
payment
AGENT Agent 2 promises to endure the pollution
in exchange for the payment which makes it better
off
57
PROPERTY RIGHTS Strict Liability Rule Applies

• Perfectly Competitive-Agent 1

• Monopoly Market Agent 1

P
D
LATC
S
LATC
MC1
MC1
PM
PPC
Strict Liability Rule
a1
58
PROPERTY RIGHTS Strict Liability Rule

• Perfectly Competitive-Agent 2

• Monopoly Market Agent 2

P
Strict Liability Rule
D
LATC
S
LATC
MC2
MC2
PM
PPC
a1
59
PROPERTY RIGHTSCoases Theorem

• .

60
PROPERTY RIGHTSCoases 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.
61
PROPERTY RIGHTSCoases Theorem
NOTE 2 Social surplus increases under the
contract. At least one party cannot be worse off.
62
PROPERTY RIGHTSCoases Theorem
NOTE 3 Social surplus is improved by the same
amount irregardless of which Agent has the
property rights.
63
PROPERTY RIGHTSCoases Theorem
NOTE 4 The distribution of the equally
improved surplus can vary depending on which
agent has the property rights.
64
PROPERTY RIGHTSCoases 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

65
PROPERTY RIGHTSCoases 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.
66
PROPERTY RIGHTSCoases 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.
67
PROPERTY RIGHTSCoases Theorem
NOTE 8 The results in Coases Theorem explain
why property rights are exchangeable like goods.
68
PROPERTY RIGHTSCoases 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?
69
PROPERTY RIGHTSCoases Theorem
70
PROPERTY RIGHTS Coases Theorem

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

71
PROPERTY RIGHTS Coases 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.

72
PROPERTY RIGHTSCoasean 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.

73
PROPERTY RIGHTSCoases 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?

74
PROPERTY RIGHTSRailways vs. Farmers
75
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.)

76
PROPERTY RIGHTSRailways 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.
77
PROPERTY RIGHTSRailways 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.

78
PROPERTY RIGHTSRailways 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 - 1979

79
PROPERTY RIGHTSRailways vs. Farmers

• Such rights of way were leased to factories or
  other compatible uses by the railways.
• Former Irwin Toy factory - Toronto

80
PROPERTY RIGHTSRailways vs. Farmers

• Over time Efficiency of Use changes
• Coases Theorem predicts these changes

81
PROPERTY RIGHTSRailways vs. Farmers
82
PROPERTY RIGHTS Defection
83
PROPERTY RIGHTS Defection

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

84
PROPERTY RIGHTS Defection

• Prisoners dilemna works against a collusive
  duopoly

• Prisoners dilemna could be solved in a
  collusive externality agency?

P.O.E
P.O.E and N. E
N.E
85
PROPERTY RIGHTSDefection

• 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

86
PROPERTY RIGHTSDefection

• Cournot Defection
• Agent 1 decides to defect from the agreed upon
  quota a1 (3/8)(1 -
  c)
• Increased Profits of Agent 1 exceed its share of
  the collusive profits (3/16)(1 - c)(1 c) gt
  (1/8)(1 - c)2

• Property and Defection

87
PROPERTY RIGHTSDefection

• Cournot Defection
• Production is scaled back to
• a1 a2 (1/3)(1 - c)
• Profits for both ultimately fall
• p1p2(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

88
PROPERTY RIGHTSDefection
a2

• Cournot Duopoly

• Negative Externality

Axes
Iso-Profit Curve For Agent 2
E
Iso-Profit Curve For Agent 1
89
PROPERTY RIGHTS Defection

• Prisoners dilemna works against a collusive
  duopoly

• Prisoners dilemna could be solved in a
  collusive externality agency? Yes.

P.O.E
P.O.E and N. E
N.E
90
PROPERTY RIGHTS

• However, prisoners dilemna works against negative
  externalities under the exceptions to the Theorem
  of Coase

• Prisoners dilemna works against a collusive
  duopoly

P.O.E
N.E
P.O.E

• N.E

91
PROPERTY RIGHTSRanchers vs. Farmers
92
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.

93
PROPERTY RIGHTS COASE THEOREM Farmer - Rancher

• 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

Grain
Nash Equilibrium a, b Cattle
94
PROPERTY RIGHTS COASE THEOREM Farmer - Rancher

• The iso-profit curve of the rancher is concave
  upwards, because as more cattle are raised, more
  of the farmers food is eaten

Grain
Nash Equilibrium a, b Cattle
95
PROPERTY RIGHTS COASE THEOREM Farmer - Rancher

• The shaded lens reflects how the parties can
  increase joint profits by co-operative behaviour

Grain
Nash Equilibrium Cattle
96
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
Common Law Nash Equilibrium Cattle
97
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
Common Law Nash Equilibrium Cattle
98
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
Common Law Nash Equilibrium Cattle
99
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
New Nash Equilibrium Cattle
100
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
No Damages Nash Equilibrium Cattle
101
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
No Damages Nash Equilibrium Cattle
102
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
No Damages Nash Equilibrium Cattle
103
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
New Nash Equilibrium Cattle
104
PROPERTY RIGHTS COASE THEOREM Direction Of
Payment

• 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

Grain
No Damages Nash Equilibrium Cattle
105
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