Lueck 8 Miceli-Property Lato Note that this solution to the externality problem embodies a particular assignment of property rights--namely, that the farmer has the right to be free from crop damage. Another way to say this is that the farmer is labeled as the "cause"of the harm and therefore must face liability. And if the property right(or the legal liability rule) is structured properly, the rancher will purchase the right to impose crop damage up to the point where the marginal profit from the last steer just equals the marginal damage, yielding an efficient herd size Coase's critique of this conventional, or"Pigovian, perspective on externalities is not that it is wrong per se, but that it is incomplete. To illustrate, suppose that the rancher initially has the economic(and legal) right to impose crop damage without penalty. According to the Pigovian view, this would result in an excessive herd size because the rancher would expand the herd to h. But note that the farmer would be willing to pay up to d(h), his marginal damage, for each steer that the farmer removes from the herd in order to avoid crop damage, while the rancher would accept any amount greater than his marginal profit, T(h). Thus, if transaction costs are zero, the parties will contract to reduce the herd to the efficient size. In other words, the farmer will purchase the rights to the straying cattle, the reverse of what happened under the Pigovian solution. The outcome in both cases is therefore first-best. This conclusion has become known as the Coase Theorem, which can be stated in general terms as follows: When transaction costs are zero, the allocation of resources will be efficient regardless of the initial assignment of property rights Coase challenged two assumptions implicit in the Pigovian view: first, that there is a unique cause of the harm, and second, that government intervention is necessary to internalize the externality. Coase noted that in general, and in the specific farmer-rancher example, the cause of harm is'reciprocalin the sense that if either party is removed, the harm disappears. Second, by noting that well defined ownership can lead to transactions, the private contracting as well as government regulation and taxation i ange of solutions extends to 1.3. The Impact of Transaction Costs: When Does Law Matter? Although there has been debate among economists and legal scholars on the significance of the Coase Theorem and its implications, Coase(1960, 1988)has been clear on this issue. Economic and legal institutions are important and have impacts because transaction costs are not zero and This tradition is attributed to A C. Pigou's The Economics of Welfare(1932) Stigler(1987)takes credit for calling this proposition the"Coase Theorem. Stigler also recounts a famous dinner at the home of Aaron Director where Coase convinced a formidable group of scholars (including Milton Friedman and Stigler) that his analysis was indeed correct. Typically economists have argued that the Coase Theorem is conditioned on the size of wealth effects. Barzel notes that the standard example of rights shifting without compensation itself violates the assumption of zero e (1997), however, argues that wealth effects are likely to be trivial and not a condition of the Coase Theorem transaction costs. This is because zero transaction costs means that a rights shift would have to be accompanied by a payment to the original rights holder In technical terms Coase points out that most interesting actions(n) depend on the inputs of both parties(a, b);that is,y=f(a, b). This"bilateral externality is discussed in section 7.1 This'contractualapproach is discussed in section 4.4Lueck & Miceli – Property Law 3 Note that this solution to the externality problem embodies a particular assignment of property rights--namely, that the farmer has the right to be free from crop damage. Another way to say this is that the farmer is labeled as the “cause” of the harm and therefore must face liability. And if the property right (or the legal liability rule) is structured properly, the rancher will purchase the right to impose crop damage up to the point where the marginal profit from the last steer just equals the marginal damage, yielding an efficient herd size. Coase’s critique of this conventional, or “Pigovian,” perspective on externalities is not that it is wrong per se, but that it is incomplete.8 To illustrate, suppose that the rancher initially has the economic (and legal) right to impose crop damage without penalty. According to the Pigovian view, this would result in an excessive herd size because the rancher would expand the herd to hr . But note that the farmer would be willing to pay up to d′(h), his marginal damage, for each steer that the farmer removes from the herd in order to avoid crop damage, while the rancher would accept any amount greater than his marginal profit, π′(h). Thus, if transaction costs are zero, the parties will contract to reduce the herd to the efficient size. In other words, the farmer will purchase the rights to the straying cattle, the reverse of what happened under the Pigovian solution. The outcome in both cases is therefore first-best. This conclusion has become known as the Coase Theorem9 , which can be stated in general terms as follows: When transaction costs are zero, the allocation of resources will be efficient regardless of the initial assignment of property rights.10 Coase challenged two assumptions implicit in the Pigovian view: first, that there is a unique cause of the harm, and second, that government intervention is necessary to internalize the externality. Coase noted that in general, and in the specific farmer-rancher example, the cause of harm is ‘reciprocal’ in the sense that if either party is removed, the harm disappears.11 Second, by noting that well defined ownership can lead to transactions, the range of ‘solutions’ extends to private contracting as well as government regulation and taxation.12 1.3. The Impact of Transaction Costs: When Does Law Matter? Although there has been debate among economists and legal scholars on the significance of the Coase Theorem and its implications, Coase (1960, 1988) has been clear on this issue. Economic and legal institutions are important and have impacts because transaction costs are not zero and 8 This tradition is attributed to A.C. Pigou’s The Economics of Welfare (1932). 9 Stigler (1987) takes credit for calling this proposition the “Coase Theorem.” Stigler also recounts a famous dinner at the home of Aaron Director where Coase convinced a formidable group of scholars (including Milton Friedman and Stigler) that his analysis was indeed correct. 10 Typically economists have argued that the Coase Theorem is conditioned on the size of wealth effects. Barzel (1997), however, argues that wealth effects are likely to be trivial and not a condition of the Coase Theorem. He notes that the standard example of rights shifting without compensation itself violates the assumption of zero transaction costs. This is because zero transaction costs means that a rights shift would have to be accompanied by a payment to the original rights holder. 11 In technical terms Coase points out that most interesting actions (Y) depend on the inputs of both parties (a,b); that is, Y = f(a,b). This ‘bilateral’ externality is discussed in section 7.1. 12 This ‘contractual’ approach is discussed in section 4.4