property rights and contracts october 10, 2006. property rights and contracts october 10, 2006 coase...

PROPERTY RIGHTS AND CONTRACTSOctober 10, 2006

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

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 Agent’s output• Marginal Revenue Curve

CONTRACTS – Terms And ConditionsOctober 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 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.


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.


What kind of a contract was McRuer J. imagining here?


Recall the “nuisance problem” discussed in the third lecture dated September 26, 2006?


• Agents operate two firms:

a1 = output of Agent 1a2 = output of Agent 2


• The profit function of Agent 1 is: 1 = pa1 – C(a1)

• The pollution function of Agent 1 is: D(a1) = (a1)^2


• Perfectly Competitive-Agent 1 • Market – Agent 1

SSD

P

a1

MC SATC


• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1

SS = MC1

DP

a1

MC1 SATC SATC

PPC

PM

LATCLATC



S

DP

a1

MC1

PPC

PM

LATCLATC


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



S

DP

a1

MC1

PPC

PM

PM

LATCLATC

No negative externality

Negative externality

PROPERTY RIGHTSStrict Liability Rule

.

Agent 2 has the exclusive use to its property 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


• The profit function of Agent 1 under the strict liability rule becomes:

1 = pa1 – C(a1) - (a1)^2

1 = 25/16



S

DP

a1

MC1

PPC

PM

LATCLATC

No Liability

Strict Liability Rule

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)* = 5/8Pollution = (a1)^2* = 25/64



S

DP

a1

MC1

PPC

PM

LATCLATC


MC1



S

DP

a1

MC2

PPCPM

LATCLATC


MC2

PROPERTY RIGHTSNo Liability Rule

.

Agent 2 loses the exclusive use to its property rights to protect it against pollution


nuisance that hurts


PROPERTY RIGHTS No Liability Rule

• The profit function of Agent 1 under the no liability rule becomes:

1 = pa1 – C(a1) 1 = 25/12 > 25/16

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 > 5/8Pollution = (a1)^2** = 25/36 > 25/64



S

DP

a1

MC1

PPC

PM

LATCLATC

No Liability

MC1



S

DP

a1

MC2

PPC

P’M

PM

LATCLATC

No Liability Rule

MC2


NEGOTIATION

PROPERTY RIGHTSCollusion

• 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 the exclusive use to its property rights to protect it against pollution


nuisance that hurts


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


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 < aP1 = 5/6?


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 – 3a1^2 + PAYMENT]


Principal

PAYMENT Agent

PROMISED PERFORMANCE

Agent

PARTICIPATIONCONSTRAINT

INCENTIVE COMPATIBILITYCONSTRAINT

LEGAL ANALYSIS

PROMISED

ECONOMIC ANALYSIS


So the participation constraint for the bribe payment offered to Agent 1 by Agent 2:

C1 = (aC1) + BRIBE > 25/12

Why? Because under no contract, Agent 1 can at the very least earn 1 = 25/12


Damages suffered by Agent 2 without the payment to Agent 1 would be:

D(aP1) = 25/36Minimum damages suffered by Agent 2 under the strict liability “ideal” would be:

D(aSO1) = 25/64



D(aP1) = 25/36However, if the ideal of “zero-pollution” operates for Agent 2 :

D(aO1) = 0Maximum Payment From Agent 2 25/36


Profit earned by Agent 1 without the payment to Agent 1 would be:

1 (aP1) = 25/12Profit earned by Agent 1 under the strict liability “rule” would be:

1(aSO1) = 25/16Minimum Payment to Agent 1 25/48


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


The incentive compatibility constraint for Agent 1 promising to cut back pollution:

(aP1) < p(aC1) + PAYMENT

where aC1 is the “contracted” level of output


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)


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


PRINCIPAL Agent 2 Offers a Bribe or a Transfer Payment To Agent 1

AGENTAgent 1 promises to cutback production or incur the expense of pollution abatement

promisepayment



S

DP

a1

MC1

PPC

PM

LATCLATC

No Liability

MC1



S

DP

a1

MC2

PPC

P’M

PM

LATCLATC

No Liability Rule

MC2

PROPERTY RIGHTSCollusion – Strict Liability Rule Applies

.

Agent 2 has the exclusive use to its property rights to protect it against pollution


nuisance that hurts



• 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


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 > aSO1


Agent 2 wants minimal pollution, but it takes into account both the payment and the pollution:

MAX [PAYMENT - D(a1)]


Principal

PAYMENT Agent

PROMISED PERFORMANCE

Agent

PARTICIPATIONCONSTRAINT

INCENTIVE COMPATIBILITYCONSTRAINT

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:

SSC2 = 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



D(aP1) = 25/64However, if the ideal of “0-pollution” operates for Agent 2 :

D(aO1) = 0Minimum Payment To Agent 2 25/64


Profit earned by Agent 1 without the payment to Agent 1 would be:

1 (aSO1) = 25/16Profit earned by Agent 1 under the free market would be:

1(aP1) = 25/12Maximum Payment from Agent 1 25/48


The “optimal” bribe or transfer payment lies within the “core”: 25/64 < PAYMENT < 25/48


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 < D(aSO1)

where aC1 is the “contracted” level of output for Agent 1


PRINCIPAL Agent 1 Offers a Bribe or a Transfer Payment To Agent 2

AGENTAgent 2 promises to endure the pollution in exchange for the payment which makes it better off

promisepayment

PROPERTY RIGHTS Strict Liability Rule Applies


S

DP

a1

MC1

PPC

PM

LATCLATC


MC1



S

DP

a1

MC2

PPCPM

LATCLATC


MC2

PROPERTY RIGHTSCoase’s Theorem

• .

COASE’STHEOREM


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.


NOTE 2:Social surplus increases under the contract. At least one party cannot be worse off.


NOTE 3:Social surplus is improved by the same amount irregardless of which Agent has the property rights.


NOTE 4:The distribution of the “equally improved” surplus can vary depending on which agent has the property rights.


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


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.


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


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


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?


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 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.


•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 RIGHTSRailways vs. Farmers

RailwaysMost 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.)


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.


• 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.


• 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


• Such rights of way were leased to factories or other “compatible uses” by the railways.

• Former Irwin Toy factory - Toronto


• Over time – Efficiency of Use changes

• Coase’s Theorem predicts these changes

PROPERTY RIGHTSDefection

DEFECTION


• If there were a Pareto superior position, would it be stable?

• If not, what would the pattern of defection be?


• Prisoners dilemna works against a collusive duopoly

• Prisoners dilemna could be “solved” in a collusive

externality agency?

P.O.E

N.EP.O.E

and N. E


• 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


• Cournot DefectionAgent 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) > (1/8)(1 - c)^2



• Cournot Defection• Production is scaled

back to:» a1= a2= (1/3)(1 - c)

• Profits for both ultimately fall:

p1=p2=(1/9)(1- c)^2

• This is an example of rent dissipation


• High transaction costs• Asymmetric

information• Too many parties

• These factors separate Nash equilibrium from Pareto optima


• Cournot Duopoly • Negative ExternalityAxes

a2

EIso-Profit Curve For Agent 1

Iso-Profit Curve For Agent 2



• Prisoners dilemna could be “solved” in a collusive

externality agency? Yes.

P.O.E

N.EP.O.E

and N. E

PROPERTY RIGHTS


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 RIGHTSRanchers vs. Farmers

Ranchers - FarmersDouble 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.


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


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


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


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


Cattle


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


Cattle


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


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



• 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


Cattle


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


Cattle


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



• 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


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

property rights and contracts october 10, 2006. property rights and contracts october 10, 2006 coase...

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