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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.
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.
PROPERTY RIGHTSContracting Property Rights
What kind of a contract was McRuer J. imagining here?
PROPERTY RIGHTSContracting Property Rights
Recall the “nuisance problem” discussed in the third lecture dated September 26, 2006?
PROPERTY RIGHTSContracting Property Rights
• Agents operate two firms:
a1 = output of Agent 1a2 = output of Agent 2
PROPERTY RIGHTSContracting Property Rights
• The profit function of Agent 1 is: 1 = pa1 – C(a1)
• The pollution function of Agent 1 is: D(a1) = (a1)^2
PROPERTY RIGHTSContracting Property Rights
• Perfectly Competitive-Agent 1 • Market – Agent 1
SSD
P
a1
MC SATC
PROPERTY RIGHTSContracting Property Rights
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
SS = MC1
DP
a1
MC1 SATC SATC
PPC
PM
LATCLATC
PROPERTY RIGHTSContracting Property Rights
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
S
DP
a1
MC1
PPC
PM
LATCLATC
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
PROPERTY RIGHTSContracting Property Rights
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 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
PROPERTY RIGHTS Strict Liability Rule
• The profit function of Agent 1 under the strict liability rule becomes:
1 = pa1 – C(a1) - (a1)^2
1 = 25/16
PROPERTY RIGHTS Strict Liability Rule
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
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
PROPERTY RIGHTS Strict Liability Rule
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
S
DP
a1
MC1
PPC
PM
LATCLATC
Strict Liability Rule
MC1
PROPERTY RIGHTS Strict Liability Rule
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
S
DP
a1
MC2
PPCPM
LATCLATC
Strict Liability Rule
MC2
PROPERTY RIGHTSNo Liability Rule
.
Agent 2 loses the exclusive use to its property rights to protect it against pollution
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 = 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
PROPERTY RIGHTS No Liability Rule
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
S
DP
a1
MC1
PPC
PM
LATCLATC
No Liability
MC1
PROPERTY RIGHTS No Liability Rule
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
S
DP
a1
MC2
PPC
P’M
PM
LATCLATC
No Liability Rule
MC2
PROPERTY RIGHTSContracting Property Rights
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
Agent 1 creates a harmful
nuisance that hurts
Agent 2 economically.
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
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 < aP1 = 5/6?
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 – 3a1^2 + PAYMENT]
PROPERTY RIGHTSCollusion – No Liability Rule Applies
Principal
PAYMENT Agent
PROMISED PERFORMANCE
Agent
PARTICIPATIONCONSTRAINT
INCENTIVE COMPATIBILITYCONSTRAINT
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 = (aC1) + 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(aP1) = 25/36Minimum damages suffered by Agent 2 under the strict liability “ideal” would be:
D(aSO1) = 25/64
PROPERTY RIGHTS Collusion – No Liability Rule Applies
Damages suffered by Agent 2 without the payment to Agent 1 would be:
D(aP1) = 25/36However, if the ideal of “zero-pollution” operates for Agent 2 :
D(aO1) = 0Maximum 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 (aP1) = 25/12Profit earned by Agent 1 under the strict liability “rule” would be:
1(aSO1) = 25/16Minimum Payment to Agent 1 25/48
PROPERTY RIGHTSCollusion – 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 RIGHTSCollusion – No Liability Rule Applies
The incentive compatibility constraint for Agent 1 promising to cut back pollution:
(aP1) < p(aC1) + PAYMENT
where aC1 is the “contracted” level of output
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)
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 RIGHTSCollusion – No Liability Rule Applies
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
PROPERTY RIGHTSCollusion – No Liability Rule Applies
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
S
DP
a1
MC1
PPC
PM
LATCLATC
No Liability
MC1
PROPERTY RIGHTSCollusion – No Liability Rule Applies
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
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
Agent 1 creates a harmful
nuisance that hurts
Agent 2 economically.
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
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 > aSO1
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)]
PROPERTY RIGHTSCollusion – Strict Liability Rule Applies
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
PROPERTY RIGHTS Collusion – Strict Liability Rule Applies
Damages suffered by Agent 2 without the payment to Agent 1 would be:
D(aP1) = 25/64However, if the ideal of “0-pollution” operates for Agent 2 :
D(aO1) = 0Minimum 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 (aSO1) = 25/16Profit earned by Agent 1 under the free market would be:
1(aP1) = 25/12Maximum Payment from Agent 1 25/48
PROPERTY RIGHTSCollusion – Strict Liability Rule Applies
The “optimal” bribe or transfer payment lies within the “core”: 25/64 < PAYMENT < 25/48
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 < D(aSO1)
where aC1 is the “contracted” level of output for Agent 1
PROPERTY RIGHTSCollusion – Strict Liability Rule Applies
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
• Perfectly Competitive-Agent 1 • Monopoly Market – Agent 1
S
DP
a1
MC1
PPC
PM
LATCLATC
Strict Liability Rule
MC1
PROPERTY RIGHTS Strict Liability Rule
• Perfectly Competitive-Agent 2 • Monopoly Market – Agent 2
S
DP
a1
MC2
PPCPM
LATCLATC
Strict Liability Rule
MC2
PROPERTY RIGHTSCoase’s Theorem
• .
COASE’STHEOREM
PROPERTY RIGHTSCoase’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 RIGHTSCoase’s Theorem
NOTE 2:Social surplus increases under the contract. At least one party cannot be worse off.
PROPERTY RIGHTSCoase’s Theorem
NOTE 3:Social surplus is improved by the same amount irregardless of which Agent has the property rights.
PROPERTY RIGHTSCoase’s Theorem
NOTE 4:The distribution of the “equally improved” surplus can vary depending on which agent has the property rights.
PROPERTY RIGHTSCoase’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 RIGHTSCoase’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 RIGHTSCoase’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 RIGHTSCoase’s Theorem
NOTE 8:The results in Coase’s Theorem explain why property rights are exchangeable like goods.
PROPERTY RIGHTSCoase’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 RIGHTSCoase’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 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.
PROPERTY RIGHTSCoase’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 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.)
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.
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.
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
PROPERTY RIGHTSRailways vs. Farmers
• Such rights of way were leased to factories or other “compatible uses” by the railways.
• Former Irwin Toy factory - Toronto
PROPERTY RIGHTSRailways vs. Farmers
• Over time – Efficiency of Use changes
• Coase’s Theorem predicts these changes
PROPERTY RIGHTSRailways vs. Farmers
PROPERTY RIGHTSDefection
DEFECTION
PROPERTY RIGHTSDefection
• If there were a Pareto superior position, would it be stable?
• If not, what would the pattern of defection be?
PROPERTY RIGHTSDefection
• 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
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
PROPERTY RIGHTSDefection
• 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
• Property and Defection
PROPERTY RIGHTSDefection
• 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
• Property and Defection
• High transaction costs• Asymmetric
information• Too many parties
• These factors separate Nash equilibrium from Pareto optima
PROPERTY RIGHTSDefection
• Cournot Duopoly • Negative ExternalityAxes
a2
EIso-Profit Curve For Agent 1
Iso-Profit Curve For Agent 2
PROPERTY RIGHTSDefection
• Prisoners dilemna works against a collusive duopoly
• Prisoners dilemna could be “solved” in a collusive
externality agency? Yes.
P.O.E
N.EP.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 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.
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